*244 Decision will be entered under Rule 50.
Petitioner's average base period net income increased over the amount determined by respondent in his partial allowance of petitioner's applications for relief under section 722 (b) (4), Internal Revenue Code, by reason of a change in the character of its business to which petitioner was committed prior to January 1, 1940. The change consisted of the addition of an envelope and writing paper manufacturing department to petitioner's regular business of manufacturing tablets and school supplies.
*35 Respondent partially disallowed petitioner's applications for excess profits tax relief under section 722 (b) (4) of the Internal Revenue *245 Code. The years involved are the fiscal years ended October 31, 1941, to October 31, 1946, inclusive. The year 1941 is involved for "carry-over" purposes only.
Some of the facts have been stipulated and are found accordingly. The following facts are found substantially as proposed by the Tax Court commissioner, with such additions as are required.
FINDINGS OF FACT.
Petitioner is a Missouri corporation with its principal place of business and office located at Springfield, Missouri. Its returns for the years involved, the fiscal years ended October 31, 1941, to October 31, 1946, inclusive, were filed with the collector for the sixth district of Missouri.
Petitioner is engaged in the business of manufacturing and selling school supplies such as tablets, composition books, memorandum pads, looseleaf notebooks, envelopes, and other related products.
Petitioner was organized in 1921 with a capitalization of $ 60,000 consisting of 600 shares of common stock of a par value of $ 100 each. It first occupied rented premises but in 1929 built its own factory, warehouse, and office building. The floor space of the factory was increased about 30 per cent in 1936. By November 1, 1936, the*246 beginning of its base period, its capitalization had been increased to $ 195,000 and it had a surplus of approximately $ 35,000.
Petitioner distributed its products through wholesalers and jobbers throughout several of the southwestern States, principally Missouri, Oklahoma, Texas, Arkansas, and Kansas. It employed a sales manager and two full-time salesmen.
In addition to its manufactured products, petitioner handled, as jobber, a limited number of products manufactured by other concerns, such as envelopes, writing paper, and looseleaf binders. It sold *36 this merchandise to its regular customers along with its own products. It was to petitioner's advantage to have a complete line of these related products so that its customers could purchase all of their supplies from one source. The profits on the jobbed products, especially the envelopes and writing paper, were comparatively small, and petitioner did not push those sales.
Petitioner's sales of its own manufactured products and jobbed products and its gross profits on such sales for each of the base period years were as follows:
| Gross sales | Gross profits | |||
| Year | ||||
| Manufactured | Jobbed | Manufactured | Jobbed | |
| 1937 | $ 350,949 | $ 30,655 | $ 91,516 | $ 2,475 |
| 1938 | 298,452 | 31,034 | 84,444 | 5,045 |
| 1939 | 356,333 | 34,788 | 95,598 | 3,936 |
| 1940 | 389,653 | 43,612 | 105,163 | 4,532 |
*247 The following table is a summary of petitioner's profit and loss statements for the base period years broken down as to the different types of products sold, cost of sales, and operating expenses:
| Fiscal year ended | ||||
| Type of product | ||||
| Oct. 31, 1937 | Oct. 31, 1938 | Oct. 31, 1939 | Oct. 31, 1940 | |
| Manufacturing | ||||
| Tablets, fillers, ream | ||||
| papers: | ||||
| Net sales 1 | $ 329,530.00 | $ 278,610.00 | $ 330,909.00 | $ 362,157.00 |
| Cost of sales 2 | 238,014.00 | 194,166.00 | 235,311.00 | 256,994.00 |
| Gross profit | 91,516.00 | 84,444.00 | 95,598.00 | 105,163.00 |
| Binders | ||||
| Net sales | 11,106.00 | 12,405.00 | 15,448.00 | 18,543.00 |
| Cost of sales | 10,640.00 | 10,428.00 | 13,937.00 | 15,594.00 |
| Gross profit | 466.00 | 1,977.00 | 1,511.00 | 2,949.00 |
| Construction paper | ||||
| Net sales | 3,048.00 | 2,637.00 | 2,825.00 | 3,060.00 |
| Cost of sales | 2,065.00 | 2,084.00 | 2,003.00 | 2,190.00 |
| Gross profit | 983.00 | 553.00 | 822.00 | 870.00 |
| Envelopes | ||||
| Net sales | 14,827.00 | 14,314.00 | 14,236.00 | 19,939.00 |
| Cost of sales | 14,054.00 | 11,923.00 | 12,926.00 | 19,226.00 |
| Gross profit | 773.00 | 2,391.00 | 1,310.00 | 713.00 |
| Package paper | ||||
| Net sales | 427.00 | 390.00 | 707.00 | |
| Cost of sales | 134.00 | 266.00 | 414.00 | |
| Gross profit | 293.00 | 124.00 | 293.00 | |
| Total gross | ||||
| profit | 94,031.00 | 89,489.00 | 99,534.00 | 109,695.00 |
| Deduct: | ||||
| Stockhandling and | ||||
| storage | 8,124.00 | 7,022.00 | 7,758.00 | 9,458.00 |
| Direct selling expense | 21,387.00 | 22,620.00 | 24,966.00 | 27,118.00 |
| Indirect selling and | ||||
| administrative | 22,487.00 | 23,312.00 | 21,891.00 | 25,926.00 |
| Other deductions (less | ||||
| other income) | 9,751.00 | 8,502.00 | 9,746.00 | 8,759.00 |
| Total | 61,749.00 | 61,456.00 | 64,361.00 | 71,261.00 |
| Net profit per | ||||
| taxpayer's audit | ||||
| reports | 32,282.00 | 28,033.00 | 35,173.00 | 38,434.00 |
| Excess profits net | ||||
| income | 31,895.66 | 27,656.34 | 35,618.68 | 38,596.30 |
| Average | 33,441.75 |
*37 Petitioner's average base period net income computed under section 713 (f) (7) of the Code, is $ 37,355.63.
For some time prior to the base period, petitioner had under consideration a plan to manufacture its own envelopes and writing paper. Many of the other manufacturers of school supplies had such departments. At a directors' meeting held October 3, 1939, a resolution authorizing that action was taken. The resolution was, in part, as follows:
J. A. MacDonnell reported to the Directors the results of his trip to the east for the purpose of obtaining information regarding cost and condition of used envelope equipment at the Eastern Tablet Corporation in Albany. Mr. MacDonnell also discussed the new type envelope machine now being built by F. L. Smithe Company and the other equipment necessary to the manufacture of envelopes.
It seemed from the information placed before the Directors by MacDonnell and Chalfant, that an investment not to exceed $ 13,000.00 would enable the Company to undertake the envelope manufacturing business on a moderate scale and on motion *249 made by Likins and seconded by Tinsley, it was moved that this expenditure be made with due diligence in an attempt to reduce the outlay. This motion was passed unanimously.
It was agreed by the Directors that the most practical machine to purchase at first would be two used Lester & Wasley machines from the Eastern Tablet Corporation, and one of the new "B" type Smithe machines. Chalfant was authorized to order these three machines and it was understood that additional equipment was to be purchased when needed.
Pursuant to the above resolution, equipment was purchased by petitioner as follows:
| Date of | |||
| Date of order | payment | Description | Cost |
| Oct. 31, 1939 | Nov. 16, 1939 | 2 -- Used Leader envelope plunger folding | $ 600 |
| machines, manufactured by Lester Wasley | |||
| Co., from Eastern Tablet Corporation. | |||
| Oct. 22, 1939 | Dec. 8, 1939 | 1 -- Used Seybold die press complete with | 1,375 |
| overhead motor and two feed roller | |||
| brackets, from Chas. N. Stevens Co. | |||
| Feb 8, 1940 | 1 -- Glue pot, New Advance Machinery Co. | 454 | |
| Oct. 20, 1939 | Aug. 31, 1940 | 1 -- Champion "B" high speed plunger, | 4,150 |
| R. P. Model, and motor equipment, | |||
| from F. L. Smithe Co. | |||
| Feb. 15, 1940 | 1 -- Harris P-2 envelope blanker | 2,350 | |
| Total | 8,929 |
*250 The first 3 above described machines were delivered to petitioner in November 1939. The 2 Leader machines were old and in bad repair and had to be completely rebuilt after about 6 months of use. The F. L. Smithe machine was delivered to petitioner in 1940. It, too, was in bad condition. In September 1940, petitioner ordered a new Smithe machine and an electric motor to operate it, at a total cost of $ 4,050, making its investment in such machinery $ 12,979. No additional machines were purchased by petitioner or specifically authorized by its directors during the base period.
*38 Petitioner began the actual production of envelopes on a commercial scale in April 1940. By October 31, 1940, the close of the base period, it had manufactured 6,483,652 envelopes. About 75 per cent of those were plain envelopes designed for business use and the rest were linen envelopes for correspondence. Petitioner continued to job some envelopes and box paper after 1940. It could manufacture on its machines only plain envelopes as distinguished from "window" and other special types and limited sizes of them. It could not supply all of the needs of its customers for its own products.
Petitioner*251 encountered considerable mechanical difficulty in getting started in the envelope manufacturing business. This was due, in part, to the poor condition of the machines which it had acquired and, in part, to the lack of skilled labor to operate them. Although there was keen competition in the industry at that time, petitioner had a number of ready customers and experienced no particular difficulty in selling its envelopes.
The following is a summary of petitioner's profit and loss statements for the years 1941 to 1947, inclusive:
| 1941 | 1942 | 1943 | 1944 | |
| Net sales 1 | ||||
| Tablets, etc | $ 392,118.07 | $ 460,902.08 | $ 498,674.40 | $ 485,095.96 |
| Envelopes, etc | 52,732.45 | 99,330.13 | 145,319.34 | 116,555.84 |
| Cost of sales | ||||
| Tablets, etc | 272,740.86 | 336,224.22 | 367,576.67 | 348,496.82 |
| Envelopes, etc | 46,668.60 | 71,204.39 | 88,277.65 | 78,873.73 |
| Jobbing | ||||
| Gross profit | 1,004.31 | 5,156.98 | 3,577.09 | 2,083.19 |
| Construction paper, etc. 2 | ||||
| Gross profit | 1,387.50 | |||
| Stockhandling and | ||||
| storage 3 | 12,154.16 | 12,218.23 | 16,038.70 | 14,067.97 |
| Expenses 3 | ||||
| Direct selling | 28,921.86 | 26,543.34 | 24,458.04 | 25,693.95 |
| Indirect selling and | ||||
| admin | 30,581.60 | 34,141.43 | 45,103.88 | 39,745.87 |
| Net profits from | ||||
| operations | 54,787.75 | 86,744.64 | 106,115.89 | 98,244.15 |
| 1945 | 1946 | 1947 | |
| Net sales 1 | |||
| Tablets, etc | $ 457,109.04 | $ 434,551.09 | $ 333,323.63 |
| Envelopes, etc | 122,869.45 | 122,843.52 | 126,462.52 |
| Cost of sales | |||
| Tablets, etc | 320,108.72 | 296,910.84 | 272,933.73 |
| Envelopes, etc | 89,729.86 | 86,939.81 | 95,770.58 |
| Jobbing | |||
| Gross profit | 6,315.61 | 2,788.44 | 9,819.46 |
| Construction paper, etc. 2 | |||
| Gross profit | 1,843.03 | 4,781.91 | 3,026.48 |
| Stockhandling and | |||
| storage 3 | 12,088.00 | 11,971.04 | 11,841.07 |
| Expenses 3 | |||
| Direct selling | 24,007.73 | 29,375.45 | 32,751.75 |
| Indirect selling and | |||
| admin | 39,238.24 | 43,181.85 | 44,714.61 |
| Net profits from | |||
| operations | 102,964.56 | 97,064.02 | 24,436.33 |
From about the close of 1939, the demand for envelopes, in proportion to the supply, increased. Petitioner had no difficulty at any time in selling its output. From 1943 through 1947 there was a governmental restriction on the supply of paper so that petitioner could not get sufficient material to fill the demand for all *253 of its paper products.
The manufacture of envelopes is known as a specialized business, that is, most of the envelopes of all types are manufactured by concerns engaged in that business exclusively. There are a great many of these small manufacturers and also a number of large ones. The industry is widely distributed throughout the country, although it is somewhat concentrated in the State of Missouri, where, in 1939, about one-twelfth of the envelope manufacturers were located.
*39 During the base period, petitioner was committed to a course of action calling for the establishment of such additions to its factory and equipment as would enable it to enter the field of manufacturing envelopes and correspondence paper.
If petitioner had begun the operation of the envelope and writing paper manufacturing department on the scale to which it was committed 2 years before it is deemed to have done so, its sales of those items at the end of the base period would have amounted to not less than 20 per cent of its total sales.
Petitioner's actual average base period income was $ 33,441.75 and, as computed under section 713 (f) (7), was $ 37,355.63. Petitioner filed claims for excess profits*254 tax relief under section 722 (b) (4) for each of the taxable years 1941 to 1946, inclusive, based on an average base period net income of $ 64,860.30. The respondent has made a partial allowance of such claims based on a constructive average base period net income of $ 31,700 for the taxable year 1941, as adjusted under the variable credit rule, ($ 38,700 for carry-over purposes only) and $ 41,300 for each of the years 1942 to 1946, inclusive.
Petitioner's average base period net income is an inadequate standard of normal earnings because of the addition to its business of the envelope and correspondence paper manufacturing department to which it was committed prior to January 1, 1940.
A fair and just amount representing petitioner's normal base period earnings to be used as a constructive average base period net income is $ 47,500.
OPINION.
Respondent has recognized petitioner's qualification for relief under section 722 (b) (4), by reason of its commitment prior to January 1, 1940, to a course of action constituting a change in the character of its business, and has made a partial allowance of petitioner's claims. In such partial allowance the respondent used a constructive average*255 base period net income of $ 41,300 for the taxable years 1942 to 1946, inclusive, whereas petitioner contends that it is entitled to a constructive average base period net income of $ 64,860.30. Its actual average base period net income was $ 33,441.75.
Our only question then is to determine what is the correct constructive average base period net income of this petitioner.
Respondent takes the position that prior to January 1, 1940, petitioner was committed to the acquisition of only 3 envelope manufacturing machines and that any reconstruction of base period net income should be based on the output of those machines only. He states in his brief:
Respondent admits petitioner changed the character of its business within the meaning of section 722 (b) (4) by reason of an increase in the capacity for *40 production as the result of a course of action to which petitioner was committed prior to January 1, 1940. The commitment consisted of a board of directors' resolution of October 3, 1939 which authorized the purchase and installation of three machines for the manufacture of certain types of envelopes previously handled by petitioner, as jobber. Pursuant to the resolution, the*256 three machines were installed prior to the close of petitioner's base period on October 31, 1940. There was no further authorization or commitment for additional machines prior to January 1, 1940.
The statutory provision pertaining to so-called commitment cases as found in section 722 (b) (4) is:
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. * * * 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 * * * shall be deemed to be a change on December 31, 1939, in the character of the business, * * *
The course of action to which petitioner was committed, as shown by the resolution of October 3, 1939, and other evidence of record, was the establishment of a new division of its business devoted to the manufacture of envelopes*257 and writing paper. The course of action encompassed not the purchase of just 3 machines but "such additions to its factory and equipment as would enable it to enter the field of manufacturing envelopes and correspondence paper." Although the directors' resolution specifically authorized the immediate purchase of 3 machines, which were said to be "the most practical machines to be purchased at first," it further stated that "it was understood that additional equipment was to be purchased when needed." In other words, the undertaking was not to be limited to these 3 first machines.
As to what may be accepted as a commitment under section 722 (b) (4), the respondent's regulations, Treasury Regulations 112, section 35.722-3 (d) (5), p. 146, provide that:
Such a commitment may be proved by a contract for the construction, purchase, or other acquisition of facilities resulting in such change, by the expenditure of money in the commencement of the desired change, by the institution of legal action looking toward such change, or by any other change in position unequivocally establishing the intent to make the change and commitment to a course of action leading to such change.
Undeniably, *258 there was an "expenditure of money in the commencement of the desired change" as well as a "change in position unequivocally establishing the intent to make the change" prior to January 1, 1940.
The requirements for a commitment within the intendment of the statute were considered at length in Studio Theatre Inc., 18 T. C. 548, where we said:
*41 The record as a whole shows in our opinion that petitioner made "changes in position unequivocally establishing the intent to make the changes [in capacity for production or operation]," and that is enough to establish the "commitment" required by the statute. S. Rept. No. 1631, 77th Cong., 2d Sess., p. 202; see also Treas. Regs. 112, sec. 35.722-3 (d).
Here, the evidence is equally convincing that at the time of the resolution of October 3, 1939, petitioner had a well formulated intention and plan to enter the envelope and writing paper manufacturing field on substantially the scale reached, and with substantially the equipment on hand, at the end of 1941.
The respondent is in error, we think, in attempting to limit petitioner's constructive base period net income to the potential of the 3 first acquired*259 machines. Petitioner's commitment was sufficient to cover, at least, the 5 machines listed above.
As set out in our findings, if petitioner had had the benefit of the 2 years' experience provided by the statute, its sales from its envelope and writing paper department would have amounted to 20 per cent of its total sales at the end of the base period. This finding is amply supported by the evidence.
Respondent's counsel objects strenuously to any consideration of post-1939 operations in the reconstruction of base period earnings because of the alleged statutory limitation of such usage found in section 722 (a). 1 However, respondent recognizes that in section 722 (b) (4) commitment cases the specific exceptions to that prohibition permit the consideration of post-base period operations to the extent necessary to determine the change in the character of the taxpayer's business. It seems to us that may include consideration of post-base period operations for the purpose of establishing the normal approximate ratio of petitioner's envelope and writing paper business to its total business, without any regard to petitioner's actual earnings in any post-base period year. The Commissioner's*260 own regulations seem to accept that construction of the statute, for they provide in Treasury Regulations 112, section 35.722-3 (d) (5), that:
To the extent necessary to determine the nature of the change in the capacity for production or operation, and the extent to which such change has been reflected in the taxpayer's business, regard may be had to facts existing after December 31, 1939. Although no regard should be had to actual earnings after December 31, 1939, as indicative of the amount of normal earnings attributable to the change, ratios existing between such earnings and earnings from other *42 operations of the taxpayer or of similar taxpayers or an industry of which the taxpayer is a member may be taken into account.
*261 In regard to the cases cited by respondent in his brief, 2 it is enough to say that none of them establishes any rule that post-1939 operations may not be considered in a 722 (b) (4) commitment case for the purpose of establishing the ratio of earnings resulting from the change in operation to those attributable to other operations. The Radio Shack Corporation case was not a commitment case. In Southern California Edison Co., 19 T. C. 935, 986, we held that there was no statutory basis, in determining constructive average base period net income, for the taxpayer's proposal for a projection, as of the end of the base period, of the additional earnings that it might reasonably expect in subsequent years as a result of the change to which it was committed. We said:
The very nature of a commitment case involves changes consummated after the base period, and of necessity one would have to consider such post-1939 events in order to make the statute effective. We need not decide here what additional post-1939 events, if any, may be taken into account, but it is clear that those post-1939 events that may be considered must be used only to the extent*262 that they are necessary to determine "normal earnings to be used as the constructive average base period net income." [Italics supplied.]
There is some evidence that there was a larger demand for envelopes in proportion to school supplies in some or all of the post-base period years than there was in the base period years but we do not think it was sufficient to require any adjustment in the ratio established. The fact is that there was a wartime increased demand for all of the products manufactured by petitioner, school supplies as well as envelopes, after the base period.
Respondent further contends that petitioner now makes claims and relies upon facts not presented in its original claims for relief, in violation*263 of the rule of Blum Folding Paper Box Co., 4 T. C. 795. What respondent objects to particularly is petitioner's use, in its proposed reconstruction, of the post-1939 factor of the proportion of envelope sales to total sales.
The rule of the Blum case excludes new issues and new facts relating to qualification for relief. We said in that case "This means that the applications must set forth not only the grounds for relief, but also a statement of the facts which the Commissioner is to consider in support of the reasons given." In Trunz, Inc., 15 T. C. 99, we said:
However, it seems appropriate at this time to mention that Blum Folding Paper Box Company, 4 T. C. 795, is not authority for some of the principles for which the Commissioner cites it. It was held in that case that this Court will not *43 consider facts which were not set forth in the application or applications for relief. The Court did not hold that evidence to support facts stated in the applications would have to be the same as that presented to the Commissioner or that the taxpayer would have to set forth in*264 its application the evidence upon which it relied to establish facts stated therein, and it did not say anything about methods of computing constructive average base period net income or restrict the taxpayer as to theories relating to that question. [Italics supplied.]
The cases cited on this point by respondent, Wadley Co., 17 T. C. 269, and Block One Thirty-Nine, Inc., 17 T. C. 1364, both dealt with qualifying issues sought to be raised before the Tax Court for the first time. In proposing the use of the post-1939 ratio of envelope sales to total sales for the purpose of reconstructing base period earnings, petitioner is not raising any new qualifying issue or offering any facts in support thereof which were not before the respondent when petitioner's claims were under consideration.
The figures as to petitioner's base period and post-base period sales of manufactured products and of jobbed products, and the earnings from such sales, have all been stipulated. We are satisfied from the evidence that, with an experience of 2 years in putting the envelope and writing paper manufacturing department in operation on*265 the scale to which it was committed, petitioner's sales of those commodities would have reached a normal level at the end of the base period of at least 20 per cent of its total sales. Using that ratio to determine the envelope and writing paper sales for all of the base period years, and taking into consideration the effect that the changed conditions would have had on operating expenses, as well as making such other adjustments as the evidence seems to require, we have determined that $ 47,500 is a fair and just amount representing petitioner's constructive average base period net income. The petitioner has made no objection to the respondent's adjustment under the variable credit rule for the fiscal year ended October 31, 1941, and effect will be given thereto under the Rule 50 computation.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. Gross sales less freight allowed.↩
2. Material, direct labor, overhead, inventory adjustment.↩
1. Gross sales less freight allowed.↩
2. Construction paper was jobbed in 1941, 1942, and 1943.↩
3. There was no segregation or allocation of stockhandling costs and expenses between envelopes and other commodities.↩
1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
(a) General Rule. -- * * * In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, except that, in cases described in the last sentence of section 722 (b) (4) and in section 722 (c), regard shall be had to the change in the character of the business under section 722 (b) (4) or the nature of the taxpayer and the character of its business under section 722 (c)↩ to the extent necessary to establish the normal earnings to be used as the constructive average base period net income.
2. Radio Shack Corporation, 19 T. C. 756; Southern California Edison Co., 19 T. C. 935; Hemenway-Johnson Furniture Co., 19 T. C. 782; Wisconsin Farmer Co., 14 T. C. 1021, 1031↩.