*141 Decision will be entered for the respondent.
1. Held: Petitioner has not shown that its business was depressed by a temporary economic circumstance (a price war) during the base period within the meaning of section 722 (b) (2), I. R. C.
2. Held: The tax computed without the benefit of section 722 is not excessive and discriminatory, and, therefore, respondent did not err in denying relief.
*1469 This proceeding arises from the respondent's disallowance of the petitioner's application for relief under section 722 (b) (2) and (b) ( 4) of the Internal Revenue Code for the calendar years 1942 and 1943.
*142 The issue is whether the petitioner is entitled, under the provisions of section 722 (b) (2) or section 722 (b) (4) of the Internal Revenue Code, to a refund of any part of the excess profits taxes paid for the calendar years 1942 and 1943.
FINDINGS OF FACT.
The petitioner was organized as a corporation under the laws of Pennsylvania in the year 1893, and maintains its principal office and place of business in Philadelphia, Pennsylvania. In 1916 the petitioner's business consisted principally of the manufacture of a paper pencil, that is, a lead pencil encased in a winding of paper. Until about 1946, petitioner was the sole manufacturer of such a pencil with a string sharpening feature. During this period all of petitioner's paper pencils had this feature. In 1916 petitioner bought out another pencil company and began the manufacture of wood pencils, that is, the ordinary type of wood cased lead pencil. Throughout the years 1922 to 1939, inclusive, it also purchased various other stationery products including mechanical pencils, leads, finger pads, crayons, lumber pencils, pens, and penholders and resold such products to its regular trade customers. Petitioner discontinued the resale of these items during the period 1939 to 1944 because that line was unprofitable. The*143 petitioner's main business continued to be the manufacture and sale of paper pencils and its wood pencil business was an adjunct to aid it in its principal line of selling paper pencils.
Prior to January 1, 1940, the petitioner's manufacturing operations in its wood pencil division were limited to the finishing of a basic pencil known to the trade as a raw stock pencil. The conversion of raw stock pencils into fully finished pencils normally involves coloring *1470 the pencil with several coats of varnish or lacquer, sanding and trimming off the ends of the pencils, stamping them with a name and adding the metal tips and erasers.
Sometime in 1937 or 1938 it was determined that the petitioner would acquire the additional equipment necessary to enable it to manufacture some of the raw stock pencils which it had previously bought entirely from the Eagle Pencil Company. By December 31, 1939, petitioner had spent $ 5,369.32 for the purchase and installation of such machinery. When it was originally determined, prior to December 31, 1939, that petitioner would begin the manufacture of raw stock pencils, it was decided that only the standard black lead raw stock pencils would be *144 made. Petitioner did not then have or plan to acquire the equipment necessary to make the thick lead black pencils, the colored crayons, or the indelible wood cased pencils. It was thought that since those items represented such a small proportion of volume and their manufacture in the raw state presented greater production problems, petitioner would continue to buy those pencils in a raw state from Eagle. Petitioner was committed within the meaning of section 722 (b) (4), on December 31, 1939, only to the manufacture of its standard diameter black lead wood cased pencils.
Petitioner made the following purchases of raw stock wood pencils during the base period:
| 1936 | 1937 | |||
| Description | ||||
| Grossage | Dollars | Grossage | Dollars | |
| S-Line for Nos. 500 and 700 | 7,929 | $ 6,739.65 | 20,878 | $ 17,893.35 |
| A Hexagon | 543 | 325.83 | ||
| B Roundedge | 98,167 | 61,301.75 | 84,933 | 51,385.44 |
| C Roundedge | 3,151 | 1,890.60 | 1,985 | 1,151.30 |
| S-D | ||||
| C-Round 6-inch | 1,300 | 585.00 | ||
| P-3-B | 459 | 642.60 | 205 | 287.00 |
| 1622 and 1623 | 1,534 | 1,365.17 | 385 | 342.65 |
| 1627 and 1628 | 245 | 306.25 | ||
| 1624 | 208 | 260.00 | ||
| 523 | ||||
| 400 | ||||
| Indelible | 774 | 1,329.96 | 368 | 610.30 |
| Thin diameter colored raw | ||||
| stock pencils | 6,179 | 12,460.13 | 9,030 | 18,095.09 |
| Standard diameter colored | ||||
| raw stock pencils | 1,127 | 2,254.00 | ||
| Total | 118,439 | 86,036.11 | 120,963 | 93,189.93 |
| 1938 | 1939 | |||
| Description | ||||
| Grossage | Dollars | Grossage | Dollars | |
| S-Line for Nos. 500 and 700 | 12,304 | $ 10,458.40 | 7,900 | $ 6,715.00 |
| A Hexagon | 247 | 163.02 | ||
| B Roundedge | 51,034 | 33,584.40 | 60,528 | 40,546.20 |
| C Roundedge | 2,195 | 1,426.75 | ||
| S-D | 1,960 | 1,097.60 | 6,041 | 3,685.81 |
| C-Round 6-inch | 3,624 | 2,391.84 | 160 | 72.00 |
| P-3-B | 118 | 165.20 | 98 | 137.20 |
| 1622 and 1623 | 2,369 | 2,240.13 | 710 | 678.50 |
| 1627 and 1628 | 425 | 561.40 | 116 | 145.00 |
| 1624 | 478 | 621.40 | ||
| 523 | 200 | 182.00 | ||
| 400 | 198 | 178.20 | ||
| Indelible | 341 | 477.83 | 399 | 462.84 |
| Thin diameter colored raw | ||||
| stock pencils | 7,763 | 15,528.00 | 8,860 | 17,720.00 |
| Standard diameter colored | ||||
| raw stock pencils | 50 | 100.00 | ||
| Total | 80,336 | 66,865.00 | 87,782 | 72,473.72 |
Petitioner was committed on December 31, 1939, only to the manufacture of those pencils on the above list down to include the P-3-B type.
The decision that the petitioner would commence the manufacture of part of the raw stock pencils previously bought from Eagle, was influenced by the fact that petitioner had experienced some difficulty in obtaining prompt delivery from Eagle of raw stock pencils. Petitioner's *1471 sales of lead pencils were influenced*146 also to a certain extent by its competitors' statements to customers to the effect that petitioner's lead pencils were not in fact made by petitioner, but by Eagle.
The manufacture of raw stock pencils generally involves the following steps: Wood slats of proper length and thickness are put through machines which make six to nine grooves in each slat. Leads are placed in the grooves of the slats and glue is spread over the surface. Other slats correspondingly grooved are placed on the top of the glued slats and the two are pressed together. The slats are then put through a cutting and shaping machine which cuts the slats into from six to nine strips depending on the width and number of grooves, with each strip constituting what is known as a raw pencil.
Petitioner did not actually commence the manufacture of any raw stock pencils until after the calendar year 1939, but it did acquire substantially all of the machinery necessary for such manufacture by that time. Petitioner also bought one carload of slats on November 13, 1939. The invoice for this shipment shows that it included two different grades of slats and some narrow strips priced as follows:
4,800 gross of AW slats *147 (a better grade) at 20 cents per gross.
8,795 gross of BW slats at 20 cents per gross.
2,000 gross of strips at 17 1/2 cents per gross. (These were never used).
In accordance with the plan that petitioner would make its own raw stock pencils, the rounding operation, using glued blocks bought from Eagle, was started on March 21, 1940. Petitioner started making its own glued blocks on October 17, 1940. By April of 1941 petitioner had acquired sufficient raw stock pencil making capacity to make all the standard raw stock pencils it needed for its own use.
The estimated cost of manufacture per gross of petitioner's standard black lead raw stock pencils is as follows, based upon the price paid for slats in 1939, lead prices prevailing in February 1941, the market price of glue in 1942, and petitioner's actual labor costs in 1942 (which were about 6 per cent higher than its labor costs in 1939):
| Labor cost for: | |
| Grooving | $ 0.00655 |
| Leading and covering | .00715 |
| Gluing and clamping | .00935 |
| Breaking and sanding blocks | .00775 |
| Final rounding and sanding | .00800 |
| Total labor cost | $ 0.03880 |
| Factory overhead | .03880 |
| Raw slats (including freight and cartage) | .253 |
| Lead | .22 |
| Glue (10 gross per pound of glue) | .023 |
| $ 0.57360 |
*148 *1472 Over a period of several years immediately prior to 1934, four of the 13 producers of wood cased lead pencils had been supplying between 70 and 75 per cent of the total domestic wood pencils produced in the United States.
The petitioner is a subsidiary of the Eagle Pencil Company, the largest of these pencil companies. Petitioner's principal stockholders also owned a controlling interest in the stock of Eagle.
The following schedule shows the amount and composition of the salaries paid to petitioner's officers for each of the years 1922 to 1939, inclusive:
| Officers' salaries -- as reported in Federal income tax returns, calendar years | |||
| 1922 to 1939 | |||
| Alfred C. | Edwin M. | Henry | |
| Year | Berol, | Berol, Vice | Berol, |
| President 1 | president 1 | Treasury 1 | |
| 1922 | $ 5,000.00 | ||
| 1923 | 5,000.00 | ||
| 1924 | 5,000.00 | ||
| 1925 | 5,000.00 | ||
| 1926 | 5,000.00 | ||
| 1927 | 5,000.00 | ||
| 1928 | 5,000.00 | ||
| 1929 | 5,000.00 | ||
| 1930 | 4,958.37 | ||
| 1931 | 4,500.00 | ||
| 1932 | 2,208.31 | ||
| 1933 | 3,633.33 | ||
| 1934 | 3,600.00 | ||
| 1935 | 4,600.00 | ||
| 1936 | 14,400.00 | $ 8,400 | $ 8,400 |
| 1937 | 14,400.00 | 12,000 | 12,000 |
| 1938 | 18,000.00 | 12,000 | 12,000 |
| 1939 | 21,000.00 | 15,000 | 15,000 |
| Officers' salaries -- as reported in Federal income tax returns, calendar years | |||
| 1922 to 1939 | |||
| Gerald L. | August | ||
| Year | Ortega, 2d | Zoll, Secretary | Total |
| Vice president | |||
| 1922 | $ 5,000.00 | ||
| 1923 | 5,000.00 | ||
| 1924 | $ 6,250.00 | 11,250.00 | |
| 1925 | 6,750.00 | 11,750.00 | |
| 1926 | 7,000.00 | 12,000.00 | |
| 1927 | 7,000.00 | 12,000.00 | |
| 1928 | 7,000.00 | 12,000.00 | |
| 1929 | 7,000.00 | 12,000.00 | |
| 1930 | 7,000.00 | 11,958.37 | |
| 1931 | 6,708.31 | 11,208.31 | |
| 1932 | 6,300.00 | 10,508.31 | |
| 1933 | 5,722.50 | 9,355.83 | |
| 1934 | 6,272.31 | 9,872.31 | |
| 1935 | 6,327.31 | 10,927.31 | |
| 1936 | 7,343.19 | $ 350 | 38,893.19 |
| 1937 | 9,000.00 | 350 | 47,750.00 |
| 1938 | 7,300.00 | 350 | 49,650.00 |
| 1939 | 9,900.00 | 350 | 61,250.00 |
The salaries paid to petitioner's officers were accepted as reasonable by the respondent in the latter's audit of petitioner's returns.
On November 1, 1938, the Federal Trade Commission issued a complaint charging 13 of the lead pencil manufacturers, a certain trade organization of which substantially all of the 13 were or had been members, and the president of that association, with having formed an illegal combination in restraint of trade to eliminate competition and fix prices in the sale of wood cased pencils. The defendants named in that proceeding included the petitioner and all major producers. On August 28, 1939, the Federal Trade Commission promulgated findings of fact in support of the complaint charging the pencil manufacturers with fixing prices. Both the complaint and the findings of fact state that in the wood cased lead pencil industry "During the year of 1935, a price war developed and lasted through 1936." On the basis of the promulgated findings of fact, the Commission entered an order on the same date enjoining the defendant manufacturers from agreeing to fix prices and various other *1473 illegal practices mentioned in the*150 findings of fact. The petitioner and other manufacturers accepted the findings of fact and the order, and filed a report showing compliance therewith.
The pencil manufacturer's trade organization referred to above has been known as the Lead Pencil Association, Inc., since about January 1937, and had 13 members at that time. This trade association was previously known as the Lead Pencil Institute, formed in May 1929, with a membership including the petitioner and practically all of the other concerns then engaged in the manufacture of wood cased lead pencils. The following schedule shows the trend of sales of domestic wood cased lead pencils for the years 1926 to 1938, inclusive:
| Shipments and sales of wood-cased lead pencils by domestic manufacturers | |||
| Average price | |||
| Year | Gross | Total sales | per gross |
| 1926 | 5,732,734 | $ 14,467,053 | $ 2.52 |
| 1927 | 6,100,349 | 14,457,827 | 2.37 |
| 1928 | 5,870,856 | 13,994,468 | 2.38 |
| 1929 | 5,596,424 | 13,816,552 | 2.47 |
| 1930 | 5,386,781 | 12,331,781 | 2.18 |
| 1931 | 4,650,589 | 10,068,380 | 2.16 |
| 1932 | 3,926,937 | 7,690,988 | 1.96 |
| 1933 1 | 3,772,829 | 7,873,569 | 2.09 |
| 1934 1 | 3,638,190 | 8,457,204 | 2.32 |
| 1935 1 | 5,320,602 | 9,461,696 | 1.78 |
| 1936 1 | 4,336,056 | 8,172,856 | 1.88 |
| 1937 2 | 5,496,998 | 9,708,612 | 1.76 1/2 |
| 1938 3 | 3,908,188 | 7,421,618 | 1.90 |
The lower priced wood pencils traditionally move on a price basis alone. Competition throughout the industry was considered "tough" for several years prior to 1935.
During 1933, the major domestic producers of wood cased lead pencils subscribed to the terms of the Reemployment Agreement made under the provisions of the National Industrial Recovery Act. A code of fair competition for the wood cased lead pencil manufacturing industry was thereafter agreed to by the representatives of the industry, which code increased minimum wages and hours of labor.
Among the new producers entering the wood cased lead pencil market prior to the base period years were businesses with plants located in the South and under the ownership or control of individuals previously connected with the industry as agents, employees, or suppliers of material. Most of these new companies specialized in the manufacture of cheaper pencils retailing for less than*152 five cents each. They felt that the minimum prices scheduled initially included in the N. R. A. Code were unduly favorable to the older and larger manufacturers in the industry. Violations of the terms of the code of fair *1474 competition occurred with increasing frequency and eventually resulted in a general disregard of the set prices even before the decision by the Supreme Court of the United States in 1935, holding the N. R. A. unconstitutional. At about the beginning of the year 1935, certain of the southern manufacturers initiated substantial reductions in the price of their pencils which led to corresponding price reductions for nearly all of the cheaper pencils made by other members of the industry. The resulting decline in prices, which had been more or less standard before the adoption of the N. R. A. Code, ranged from 30 cents per gross for some items to $ 1.25 per gross for others. The greatest price cuts were made in so-called imitation 5-cent pencils which retailed at three for 10 cents. The additional emphasis on price competition beginning in 1935 and thereafter, resulted in a considerable deterioration in the quality of the cheaper wood pencils. This *153 was also true of the 5-cent pencils and of substantially all the wood pencils sold in any volume by the smaller companies. The wholesale price of all commodities showed a sharper decline below the 1926 average than wood pencil prices in each of the years 1930, 1931, and 1932. By 1935, this trend was reversed and wood pencil average wholesale prices declined and came more into line with the general business average.
Several of the relatively small companies which were new in the field, and including those which cut their selling prices most severely, found themselves in serious financial difficulty toward the end of the base period as a result of the increased degree of price competition prevailing in the industry after 1935. The production of these smaller companies was small in comparison with the total production of the industry, but it was sufficient in the aggregate to compel the older manufacturers to meet price reductions instituted by the smaller companies in order to avoid any substantial loss of business.
The southern mills continued to enjoy lower production costs than their northern competitors throughout the base period. Petitioner's production employees became unionized*154 in July of 1937 and there was a marked increase amounting to about 17 1/2 per cent in petitioner's labor costs at that time. The small size and emphasis on cheaper pencil production also enabled the southern companies to minimize their selling and administrative expenses. The petitioner's administrative and selling expenses were relatively high and the southern companies were in a position to make a profit on the sale of their pencils at a price which the petitioner could not meet without losing money.
It was the common practice of the older and larger companies, including the petitioner, to date invoices on either the first of March or the first of September after the date of shipment and to allow customers the usual cash discounts on the invoice. This deferred billing *1475 practice results in the extension of credit for several months on cash terms and enables the manufacturer to procure a large quantity of advance orders. Some of the southern companies which were operating on relatively small capital were unable to follow this billing practice. The extended credit terms resulting from the practice of postdated billing operated to the manufacturers' disadvantage when *155 prices were declining because of the necessity of giving customers who placed their orders before the decline in price the benefit of any price reductions occurring before the goods were shipped.
During the base period the petitioner was one of only three paper cased pencil producers in the United States and there had been no change in that number since about 1920 or 1922. Petitioner's paper pencils were made in a wide variety of styles. All of its paper pencils and paper wrapped erasers were made with a special string sharpening arrangement on which the petitioner had obtained the patent in about 1930. These items were in demand by almost every dealer in the United States and petitioner alone was in a position to supply them. Such circumstances made the petitioner's relations with its dealers more secure than the relationship enjoyed by other wood pencil manufacturers and thus enabled the petitioner to procure orders for wood pencils which otherwise it would not have been able to obtain.
The following schedule shows the average price of all paper pencils and wood pencils sold by the petitioner during each of the calendar years 1922 to 1939, inclusive, with the corresponding wholesale*156 price index for all commodities as compiled by the Bureau of Labor Statistics of the United States Department of Labor:
| Average sales price per gross | |||
| Index of wholesale | |||
| Year | Paper pencils | Wood cased | prices |
| pencils | (1926 = 100) | ||
| 1922 | 5.60 | 2.52 | 96.7 |
| 1923 | 5.74 | 2.47 | 100.6 |
| 1924 | 5.09 | 2.80 | 98.1 |
| 1925 | 4.75 | 2.46 | 103.5 |
| 1926 | 6.12 | 2.23 | 100.0 |
| 1927 | 5.56 | 2.06 | 95.4 |
| 1928 | 4.98 | 2.03 | 96.7 |
| 1929 | 5.39 | 2.14 | 95.3 |
| 1930 | 5.69 | 1.86 | 86.4 |
| 1931 | 5.80 | 1.85 | 73.0 |
| 1932 | 6.38 | 1.64 | 64.8 |
| 1933 | 6.43 | 2.04 | 65.9 |
| 1934 | 6.31 | 2.26 | 74.9 |
| 1935 | 6.98 | 1.55 | 80.0 |
| 1936 | 7.34 | 1.59 | 80.8 |
| 1937 | 7.29 | 1.64 | 86.3 |
| 1938 | 7.61 | 1.71 | 78.6 |
| 1939 | 7.68 | 1.77 | 77.1 |
The petitioner did not increase the sale price of any of its paper pencils after 1934. The increase in the average selling price of its *1476 paper pencils after 1935 and 1936 was entirely attributable to increased sales of more expensive paper pencils and a decrease in the number of cheaper paper pencils sold. Petitioner was able to increase its gross profit margin on paper pencils during the base period primarily by reason of the shift in sales volume to the more expensive line and to some*157 extent by reason of a reduction in manufacturing costs. This reduction in manufacturing costs was effected in both the petitioner's wood pencil and paper pencil manufacturing operation beginning in the latter part of 1935, when the petitioner employed an industrial engineer who became its factory manager a year or two later. The engineer adapted to the petitioner's manufacturing operation a procedure of work simplification resulting from certain motion study methods. The principal changes consisted of the separation of the wood and paper pencil production line, the addition of automatic conveyers in such a way as to eliminate hand feeding in certain of the machines and to provide for continuous operation and the rearrangement of machinery so as to reduce the number of operating employees. These changes were effected in the years 1937 and 1938. One of the major economies resulting from this modernization of the production line consisted of the elimination of about three and a half machine operators or helpers whose wages would aggregate about $ 3,500 a year.
The following schedule compares the petitioner's gross sales, gross profits and net operating profits (or losses) in dollars*158 for its wood and paper pencil divisions for the years 1922 to 1939, inclusive:
| Gross sales 1 | Gross profits | |||
| Year | ||||
| Wood pencils | Paper pencils | Wood pencils | Paper pencils | |
| 1922 | 305,329.47 | 266,081.28 | 60,682.70 | 127,742.58 |
| 1923 | 344,759.94 | 282,565.48 | 66,095.91 | 127,951.13 |
| 1924 | 311,850.45 | 269,456.04 | 51,068.75 | 107,848.15 |
| 1925 | 286,510.80 | 280,536.76 | 52,621.98 | 128,253.82 |
| 1926 | 211,861.65 | 262,385.32 | 28,156.45 | 107,692.58 |
| 1927 | 234,570.79 | 258,175.46 | 27,471.96 | 114,054.30 |
| 1928 | 191,833.89 | 268,035.36 | 28,755.79 | 119,594.79 |
| 1929 | 190,416.40 | 304,612.22 | 29,396.87 | 146,169.87 |
| 1930 | 150,178.81 | 248,781.47 | 17,331.37 | 108,110.47 |
| 1931 | 131,302.32 | 194,657.54 | 19,803.69 | 85,184.10 |
| 1932 | 124,592.94 | 147,825.52 | 18,925.82 | 67,542.87 |
| 1933 | 132,455.57 | 166,215.30 | 25,143.45 | 81,050.29 |
| 1934 | 160,528.27 | 191,778.38 | 30,743.86 | 87,540.87 |
| 1935 | 222,151.09 | 212,622.35 | 31,033.56 | 107,442.48 |
| 1936 | 202,744.95 | 251,392.35 | 26,141.31 | 130,180.12 |
| 1937 | 193,406.78 | 276,807.32 | 22,531.43 | 136,098.45 |
| 1938 | 181,250.67 | 235,484.09 | 24,272.57 | 126,121.84 |
| 1939 | 179,621.16 | 271,790.69 | 40,992.54 | 139,848.90 |
| Net operating profits | ||
| Year | ||
| Wood pencils | Paper pencils | |
| 1922 | 13,682.90 | 86,784.40 |
| 1923 | 8,780.78 | 80,975.61 |
| 1924 | (11,046.28) | 54,177.33 |
| 1925 | (989.81) | 75,759.89 |
| 1926 | (16,819.58) | 51,909.53 |
| 1927 | (18,122.14) | 64,584.70 |
| 1928 | (13,380.71) | 60,720.57 |
| 1929 | (11,777.75) | 80,302.16 |
| 1930 | (18,255.46) | 44,450.57 |
| 1931 | (12,723.83) | 19,097.95 |
| 1932 | (15,471.99) | 25,641.73 |
| 1933 | (7,583.87) | 38,306.71 |
| 1934 | (6,136.03) | 45,602.17 |
| 1935 | (16,412.80) | 62,035.56 |
| 1936 | (29,170.17) | 61,601.18 |
| 1937 | (32,633.20) | 57,137.33 |
| 1938 | (36,709.81) | 46,890.77 |
| 1939 | (17,869.97) | 50,805.76 |
The following schedule shows the petitioner's total gross sales of all products, and total net income from all sources and excess profits net income: *1477
| Gross sales of | Total net | Excess profits | |
| Year | all products 1 | income | net income |
| 1922 | $ 816,979.95 | $ 143,249.45 | $ 143,228.95 |
| 1923 | 772,125.63 | 111,813.01 | 111,663.01 |
| 1924 | 696,197.56 | 61,563.42 | 61,743.42 |
| 1925 | 681,455.64 | 77,868.28 | 77,512.76 |
| 1926 | 587,597.14 | 27,169.46 | 27,169.46 |
| 1927 | 608,092.01 | 44,015.04 | 43,702.79 |
| 1928 | 571,888.45 | 43,403.78 | 43,374.63 |
| 1929 | 600,110.47 | 70,541.84 | 70,598.09 |
| 1930 | 479,448.64 | 24,834.49 | 23,659.49 |
| 1931 | 368,702.64 | 1,827.65 | 1,827.65 |
| 1932 | 296,826.68 | 11,403.31 | 11,759.67 |
| 1933 | 318,916.78 | 31,191.49 | 31,191.49 |
| 1934 | 372,055.12 | 42,333.41 | 42,028.28 |
| 1935 | 459,117.57 | 49,402.97 | 49,025.47 |
| 1936 | 477,691.29 | 34,705.76 | 34,525.76 |
| 1937 | 498,955.03 | 27,687.77 | 27,536.52 |
| 1938 | 441,315.35 | 15,773.20 | 15,540.70 |
| 1939 | 481,473.64 | 38,016.47 | 38,016.47 |
*160 The petitioner's excess profits credits for the taxable years as determined on the invested capital basis and without the benefit of section 722 are as follows:
| Excess profits | |
| Year | tax credit |
| 1942 | $ 39,052.37 |
| 1943 | 52,784.76 |
The following schedule shows the dates and amounts of the payments, (including credits) made by the petitioner on its excess profits tax liabilities for the calendar years 1942 and 1943:
| 1942 payments | 1943 payments | ||
| Date | Amount | Date | Amount |
| 3-15-43 | 1 $ 24,000.00 | 3-15-44 | 1 $ 22,000.00 |
| 6-18-43 | 25,626.51 | 6-16-44 | 19,171.20 |
| 9-14-43 | 20,518.45 | 9-20-44 | 20,585.60 |
| 11-17-43 | 20,518.45 | 12-15-44 | 20,585.60 |
| 2-8-46 | 3 1,083.49 | 2-8-46 | 2 940.06 |
| 3-5-46 | 3 243.62 | 3-5-46 | 3 582.65 |
| 4-12-46 | 11,119.77 | 4-12-46 | 8,712.44 |
| Total credits | 103,110.29 | Total credits | 92,577.55 |
The stipulated facts are so found and in so far as they are pertinent to the issue, are incorporated in our findings of fact above.
OPINION.
The petitioner contests the respondent's disallowance of its claim for relief*161 under section 722 (b) (2) and (b) ( 4) *1478 of the Internal Revenue Code. 1 Petitioner contends that its base period net income was not normal because its business was depressed in the base period due to a temporary economic circumstance -- a price war -- such as to warrant relief under section 722 (b) (2). Petitioner contends further that it should be entitled to relief under section 722 (b) (4), alleging that it was committed on January 1, 1940, to a change in the character of its business. Petitioner's excess profits tax returns for the taxable years 1942 and 1943 show credits of $ 39,052.37 and $ 52,784.76, respectively, computed on the invested capital basis. Petitioner now seeks to show that its excess profits credits for the taxable years, computed under the average earnings method and using an average base period net income reconstructed under the provisions of section 722, exceed the credits available to it on the invested capital basis of computation. See Regs. 112, sec. 35.722-1.
*162 Under section 722 (b) (2), petitioner must show that its average base period net income is an inadequate standard of earnings because its business was depressed in the base period due to a temporary economic event unusual in its industry and that the excess profits tax *1479 determined without the benefit of section 722 is excessive and discriminatory. Petitioner must further establish what would be a fair and just amount representing normal earnings to be used in a constructive average base period net income.
Petitioner contends that the temporary economic event in its industry was a "ruinous price war" which depressed the whole industry and consequently its own business. Petitioner's witnesses, men connected with the pencil manufacturing business, so described the status of competition in the industry between 1935 and 1939. The Federal Trade Commission, in a suit charging the wood cased pencil manufacturers with price fixing, also stated that a price war existed in 1935 and 1936.
There is no mention in the Code of a price war as being a temporary economic event within the meaning of section 722 (b) (2). Respondent's regulations, however, (Regulations 112, section 35.722-3) *163 justify petitioner's contention that a price war, if proven to exist, is a temporary economic event such as might cause the base period net income of a member of the industry to be considered depressed. The proof must establish both the existence of the event and the fact of the depression.
It is well to note the emphasis, in both the Regulations and the Code, placed upon the word "temporary." The record here shows that competition in the wood cased lead pencil industry was based largely on price in the years 1936 to 1939 (particularly in the cheaper pencils which constituted most of the volume). The proof does not show that this condition was more "temporary" or less general than competition between members of any other industry during that period. To characterize a condition as a "price war" is not an end of petitioner's burden of proof. Inasmuch as the years 1936 to 1939 are prescribed by law as the base period, the answer to the question whether competition in any particular business during that period could be termed a qualifying price war, must depend to a large extent on comparison with contemporary competition in other businesses. Petitioner's gross profits in its wood*164 pencil division changed very little during the base period years. In the years prior to 1934 and 1935 the old and established northern manufacturers enjoyed comfortable profits. The entry into the field of the several southern manufacturers of wood cased lead pencils was the cause of the competition which the petitioner contends depressed its business. There was, however, nothing temporary about the existence of the southern manufacturers who were partly the cause of the alleged "price war" -- they were in the industry to stay. It was but natural that these new companies should compete in any manner open to them, viz., on the basis of more favorable prices at which they were willing to sell their product. In order *1480 to retain their share of business the older companies were in turn forced to cut prices. The petitioner's witnesses characterize this sort of competition as ruinous and stated that it was the purpose of the new competitors in reducing their prices, below the former levels, principally to break the older manufacturers and drive them out of the business. Petitioner's witness testified that "There are certain kinds of pencils in the pencil industry which largely*165 move on price and price alone. There are other kinds of pencils that move on the basis of quality and the number of people who recognize the quality and are willing to pay a reasonable price for that quality, and the number of people who know the quality depends upon the kind of advertising, promotion and sales job that you do."
In our opinion, the characterization of this competition as a "ruinous price war" has fallen short of establishing within the meaning of the Code that it was a temporary economic event. This is not to say that petitioner would qualify if the price war existed but for a short time or that it would not qualify if the same conditions existed for all of the base period. The fact remains that for the demand that existed during the base period for the petitioner's product in question, there apparently existed a greater number of suppliers than could profitably share the business available. Such being the situation, it is impossible for us to say that the competition of those suppliers for the limited demand, even if that competition be characterized as a "price war," was a temporary economic event. Apparently competition was always keen in the pencil manufacturing*166 business. It is important to note in this connection that it was conceded by petitioner's witnesses that the end of the alleged "price war" was due in a large part to the increased demand for pencils following the beginning of the war in Europe in 1939. It was due to this factor that the close competition in the base period was somewhat lessened. But for the increased demand in 1939, competition in the industry would have continued on the same basis. If competition had been as ruinous during the base period as contended by petitioner, we would expect the elimination of the marginal producers. Harlan Bourbon & Wine Co., 14 T. C. 97. Yet after four or five years of close competition, only one or two pencil manufacturers were eliminated and they were almost immediately replaced by others. This does not indicate that the competition in which petitioner found itself was temporary and unusual. Winter Paper Stock Co., 14 T.C. 1312">14 T. C. 1312.
There is another aspect of the question under section 722 (b) (2) which petitioner has failed to meet. Even if the other members of the industry were depressed, petitioner must show that because*167 of the "price war" its business was depressed during the base period. The evidence shows that the wood cased lead pencil division of petitioner's *1481 business was merely an adjunct to its principal business of manufacturing paper cased pencils. The testimony was to the effect that since petitioner had a profitable business in paper cased pencils it did not enter, to any great degree, the close competition for sales of cheap wood pencils but "stayed away" from that type of competition as much as possible. Petitioner had an exclusive patent process on one type of paper cased pencil and was competing with only two other firms as to another type. The evidence shows that petitioner initially entered the wood cased pencil field principally in order to assist its sales of paper cased pencils. Also, petitioner is closely affiliated with the largest producer of wood cased pencils from whom, until after 1939, it bought its wood cased pencils in rough form, merely finishing the raw product and stamping it with its own name. The inference from the record is that the coordinate policy of the two affiliates was that petitioner would concentrate on its profitable line of paper cased*168 pencils and its affiliate would manufacture for petitioner its wood cased pencils. Since petitioner's wood cased pencil division showed a net loss in every year after 1924, it is apparent that the continuation of that line was for reasons other than a direct profit thereon. Petitioner stopped making several items of miscellaneous stationery supplies because they were unprofitable, yet it continued to make the wood pencils at a substantial net loss in every year. Petitioner stated in support of its application for relief that:
The manufacture and sale of wood encased pencils is necessary and imperative in order to make possible the sale of paper pencils. This is true because in order to meet competition, salesmen are obliged to carry a complete line of wood encased pencils as well as paper pencils so that customers can buy from one source, all requirements of pencils and thus eliminate the purchase of paper pencils from one source and wood encased pencils from another.
The manufacture and sale, therefore, of wood encased pencils has become a necessary adjunct to the manufacture and sale of paper pencils, and in grossage, the sale of wood encased pencils has greatly exceeded the*169 sale of paper pencils although the average price per gross of paper pencils is far greater than the average price per gross of wood encased pencils. * * *
The question of the normalcy of the losses shown in the base period years by petitioner's wood cased pencil division, should be examined in a somewhat different light than if the division were self-sufficient.
Apparently the petitioner and its affiliate shared the services of the officers of the two companies, but in a degree not explained in the record. Petitioner speaks in its brief of its officers giving "concurrent services to the Eagle Pencil Company, their other employer * * *." Respondent contends that the increased losses in the wood cased pencil division during the base period were due to the large increases in salary paid to petitioner's officers. Petitioner's witness stated that the officers had been doing the same job since 1920 and that their increased salaries during the base period had been accepted *1482 as reasonable by the respondent in the latter's audit of petitioner's returns. The fact is clear, however, that there would have been no increase in the losses continually suffered by petitioner in the*170 wood cased pencil division had these salary increases not been made during the base period. Petitioner is in the anomalous position of arguing that it was in a "ruinous price war" during a period when it more than tripled its officers' salaries. The amount of those salary increases was considerably greater than the amount petitioner claims its business was depressed because of the alleged price war. The fact that respondent allowed a deduction for the salaries proves nothing here.
In our opinion, the petitioner has not shown that its business was depressed during the base period within the meaning of section 722 (b) (2) of the Code.
We come next to the petitioner's contention that it is entitled to relief under section 722 (b) (4) of the Code.
In 1939, the decision was made that the petitioner would acquire the necessary equipment and begin the manufacture of the raw stock pencils of the standard diameter black lead type which it had previously bought from its affiliate, the Eagle Pencil Company. To that end the petitioner bought machinery designed for the purpose of such manufacture although it did not acquire all of the machinery so needed until sometime in 1940. In 1939, the*171 petitioner also acquired a substantial amount of the wood slats from which the raw stock pencils are made. By October 1940 the petitioner was, to a limited extent, manufacturing its raw pencil needs, at least insofar as the standard diameter pencils were concerned. By the end of 1941 the petitioner was manufacturing all of its standard diameter pencils and had begun the gluing operation on some of the colored pencils and on some of the indelible pencils. There is a serious question as to just which of the petitioner's pencils it was committed to manufacture on December 31, 1939. The testimony of the petitioner's witnesses shows that by December 31, 1939, the decision was to manufacture only the standard diameter black lead pencils and later, after the manufacture of those pencils was begun, it was determined that the petitioner would expand and enter upon the manufacture of the other pencil lines. We have found as a fact that petitioner was committed on December 31, 1939, only to the manufacture of its standard diameter black lead pencils.
Petitioner can therefore reconstruct its net income only with consideration for what it was committed to do on December 31, 1939. That is, *172 the reconstruction can include only what petitioner would have saved from the manufacture instead of the purchase of standard diameter black lead wood cased pencils.
*1483 In the petitioner's reconstruction of its average base period net income the largest amounts representing the increases in petitioner's net income under its claim for relief under section 722 (b) (2) involve the alleged price war. We have determined above that the petitioner is not entitled to relief under that section and by excluding from its reconstruction the amounts involving 722 (b) (2) relief, we see that petitioner claims reconstructed income in the base period years as follows:
| Net income as | ||||
| Saving at | Reported | reconstructed | ||
| Gross amount | $ 0.19 per | ncome | by addition of | |
| Year | sold | gross | amount saved | |
| 1936 | $ 127,410 | $ 24,207.90 | $ 34,525.76 | $ 58,733.66 |
| 1937 | 117,664 | 22,356.16 | 27,536.52 | 49,892.68 |
| 1938 | 105,818 | 20,105.43 | 15,540.70 | 35,646.13 |
| 1939 | 101,531 | 19,290.89 | 38,016.47 | 57,307.36 |
| Total | 201,579.83 | |||
| Average reconstructed | ||||
| base period net income | 50,394.96 |
The substance of this claim is that petitioner alleges that it paid between 77*173 cents and 79 cents per gross for its standard diameter black lead pencils during the base period years and that the changes in manufacture to which it was committed on December 31, 1939, would have enabled it to have manufactured those pencils at an average of 58 cents per gross, representing a saving in manufacturing cost of the raw pencil of approximately 19 cents per gross. The respondent contends that the petitioner's purchase costs include the higher costs of the indelible pencils and the colored lead pencils, the manufacture of which the petitioner was not committed to on December 31, 1939.
The respondent also contends that the petitioner's figure, representing what it would have cost to manufacture its own raw stock pencils during the base period, is not accurate inasmuch as those costs were based largely on post base period costs which the facts show were somewhat higher than they would have been during the base period. This difference is immaterial for reasons which follow and for purposes of considering the argument we accept the cost figure of 58 cents.
It is further apparent that had petitioner been manufacturing during the base period the standard diameter black lead*174 wood cased lead pencils instead of buying the raw stock pencils, its saving should be based on the number of gross of raw pencils bought, not the number of finished pencils sold as was done in petitioner's computation above. By referring to the list of purchases of raw stock pencils in the Findings of Fact and using the first seven items which we have determined *1484 were the only ones petitioner was committed to manufacture on December 31, 1939, we arrive at purchases of those pencils in each year, as follows:
| Year | Gross |
| 1936 | 109,706 |
| 1937 | 109,844 |
| 1938 | 69,040 |
| 1939 | 77,169 |
| Total | 365,759 |
Petitioner paid for these purchases of raw stock pencils in each year, the following total amounts:
| 1936 | $ 70,574.60 |
| 1937 | 71,627.92 |
| 1938 | 47,697.44 |
| 1939 | 52,745.98 |
| Total | $ 242,645.94 |
By dividing the total cost by the total bought we arrive at an average cost per gross of $ .66.
If we accept petitioner's figure of 58 cents representing what it contends it would have cost to make each gross, then a saving of 8 cents per gross results. The total purchases of these pencils during the base period were 365,759 gross, which if made by petitioner at a *175 saving of 8 cents per gross, would be an addition to petitioner's total reported base period income as follows:
| Total base period reported income | $ 115,619.45 |
| Saving at 8 cents on purchases | 29,260.72 |
| Total base period income, reconstructed | $ 144,880.17 |
| Average | $ 36,220.04 |
This figure represents the petitioner's average base period net income reconstructed to allow for the amount it would have saved had it been manufacturing during that period, the pencils it was committed to manufacture on December 31, 1939. This computation thus gives effect to a reconstruction of the entire base period income which we hold did not otherwise "reflect the normal operation" within the meaning of section 722 (b) (4). Cf. the manner of computation in Lamar Creamery Co., 8 T. C. 928; E. P. C. 31, 1948-1 C. B. 93. Petitioner is thus entitled to use a credit based on a constructive average base period net income of $ 36,220.04. This amount exceeds the credit otherwise computed under the average earnings method without the benefit of section 722. But petitioner gains no advantage by the reconstruction of net income under section *176 722 (b) (4) for the reason that it is entitled to credits of $ 39,052.37 and $ 52,784.76 for the taxable years 1942 and 1943 under a computation based on the invested capital method.
*1485 We hold that the tax computed without the benefit of section 722 is not excessive and discriminatory and that therefore respondent did not err in denying relief.
Another issue relating to petitioner's carry-over of unused excess profits tax credits has been rendered moot by our holding on the primary issue.
Decision will be entered for the respondent.
Footnotes
1. Principal stockholders.↩
1. Nine companies reporting.↩
2. Thirteen companies reporting for January to October, twelve for November and December.↩
3. Twelve companies reporting January and February, thirteen March to September, eleven October and November, ten December.↩
1. After returns but before discounts and allowances, except for the years 1922 and 1923 where the figures are before discounts and allowances only.↩
1. After returns but before discounts and allowances, except for the years 1922 and 1923 where the figures are before discounts and allowances only.↩
1. Tentative payment.↩
3. Credit arising out of income tax overassessment.↩
2. Post war credit offset against deficiency assessment.↩
1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
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(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 --
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(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.
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(4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the purposes of this subparagraph, the term "change in the character of the business" includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, a difference in the ratio of nonborrowed capital to total capital, and the acquisition before January 1, 1940, of all or part of the assets of a competitor, with the result that the competition of such competitor was eliminated or diminished. Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, or
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