*82 Decision will be entered under Rule 50.
1. Petitioner, a manufacturer of twist drills, held qualified for excess profits tax relief under section 722 (c) (1), Internal Revenue Code of 1939, because intangibles not includible in invested capital made important contributions to income.
2. Held, further, that the excess profits credit based on invested capital was an inadequate standard for determining excess profits for the fiscal year ending June 30, 1942, but was not an inadequate standard for the fiscal years ending June 30, 1943, 1944, and 1946.
3. Constructive average base period net income determined for the fiscal year ending June 30, 1942.
*1127 This proceeding involves the Commissioner's disallowance of claims for refund of excess profits tax for the years ended June 30, 1942, 1943, 1944, and 1946, in amounts as follows:
| Year ended | |
| June 30 | Amount |
| 1942 | $ 355,749.19 |
| 1943 | 753,913.24 |
| 1944 | 138,081.66 |
| 1946 | 103,559.14 |
The only questions in issue are whether petitioner, whose excess profits credit was necessarily computed under the invested capital method, because it was not in existence during the base period, is entitled to excess profits tax relief under section 722 (c) either because intangible assets not included in invested capital made important contributions to income or because its invested capital was abnormally low; and if so, what is a fair and just amount to be used as a constructive average base period net income for computing its excess profits credit under the income method.
FINDINGS OF FACT.
Part of the facts are stipulated and are incorporated herein by this reference.
Petitioner *84 is a Delaware corporation with its principal office located at Chicago, Illinois. Its returns were filed with the collector of internal revenue for the first district of Illinois. The returns were made on an accrual basis for a fiscal year ending June 30.
Petitioner is engaged in the business of manufacturing twist drills. The business was organized by Clarence Avildsen as a sole proprietorship *1128 about September 1, 1940, under the name of Republic Drill & Tool Company. Its was incorporated under that name July 16, 1941. Its name was changed to its present name, Avildsen Tools & Machines, Inc., March 2, 1949.
Petitioner's founder, Clarence Avildsen, has been in some manner associated with the twist drill business since about the close of World War I. He was first employed at the age of 20 years as a salesman by A. C. Blanke & Company of Chicago, a jobber, principally, of twist drills and high speed steel bars. After about 1 year he was employed, first as a buyer and later as tool department manager, by McMaster Carr Supply Company of Chicago, a dealer in industrial supplies, including twist drills. About a year later he organized his own business under the name of Valley*85 Forge Steel & Tool Company. This business was incorporated and Avildsen acquired 50 per cent of its stock.
Valley Forge Steel & Tool Company, hereinafter referred to as Valley Forge, conducted a brokerage business dealing in surplus stock of twist drills and high speed steel bars which it sold to industrial firms throughout the country. Later, after the surplus stock had been diminished, it began purchasing twist drills from established drill manufacturers.
Under Avildsen's guidance as chief executive, Valley Forge employed a selling technique described as an exchange plan whereby it allowed its customers, who would obligate themselves to purchase from it a substantial portion of their twist drills and reamers at market prices, the right to pay for 15 or 20 per cent of their purchases in surplus drills, steel bars, or other materials which they might want to dispose of. These surplus materials would then be sold at whatever price could be obtained for them.
Under this plan of operation, Valley Forge soon developed into the country's leading jobber of twist drills. After World War I a great many tool manufacturers and industrial concerns had found themselves with large quantities*86 of unsalable or unusable drills and other products which they were glad to dispose of in this manner. Among Valley Forge's customers were Caterpillar Tractor Company, Allis Chalmers Manufacturing Company, Pullman Company, Timken Detroit Axle Company, Westinghouse Electric, John Deere & Company, and others.
In 1930 Valley Forge was merged with Latrobe Tool Company, hereinafter referred to as Latrobe, a manufacturer of twist drills, with plants at Latrobe, Pennsylvania, and Pawtucket, Rhode Island. Valley Forge was then purchasing about one-half of Latrobe's output of twist drills. After the merger Latrobe, as the surviving entity, continued to operate the two twist drill plants, as well as the Valley *1129 Forge enterprise in Chicago. Avildsen became the chief executive officer of Latrobe.
In 1933 Latrobe was merged with another twist drill manufacturer, Whitman & Barnes, Inc., which was then operating a twist drill plant in Detroit. Whitman & Barnes, Inc., was in financial difficulties and, although in the merger it furnished about 70 per cent of the physical assets, its stockholders received only 30 per cent of the stock of the new corporation. The other 70 per cent was*87 issued to Latrobe's stockholders.
This merger resulted in the formation of a new corporation, United Drill & Tool Corporation, hereinafter referred to as United. Avildsen became its chief executive officer and chairman of the board of directors.
United continued to operate its twist drill plants and also the sales office and warehouse business in Chicago throughout the base period. The business expanded until its sales of twist drills amounted to about 20 per cent of the total sales in the United States.
Avildsen resigned as chief executive of United in August 1939 with the intention, however, of going back into the twist drill manufacturing business. He remained on the board of directors until he could liquidate his holdings in the company, which was in June 1940. In the interim he served in Washington, D. C., as Special Assistant to the Secretary of Commerce, Harry Hopkins, representing the Department of Commerce on the Temporary National Economic Committee.
About September 1, 1940, Avildsen organized Republic Drill & Tool Company, the sole proprietorship referred to above as petitioner's predecessor, with its plant located in Chicago. The proprietorship continued to operate*88 the business until it was taken over by the petitioner corporation about August 1, 1941. It had net sales of $ 24,161.85 for the 10-month period ended May 31, 1941, $ 58,016.90 for the month of June 1941, and $ 71,165.28 for the month of July 1941. It had no net profits.
On August 1, 1941, Avildsen transferred to petitioner certain assets of the proprietorship in exchange for 99,000 of its 100,000 authorized shares of $ 1-par-value common stock. There had been previously issued to Avildsen 1,000 shares of this stock for paid-in cash. The assets in question were entered in petitioner's books at their adjusted basis to Avildsen, as follows:
| Adjusted basis to Avildsen on | |
| date of transfer and as | |
| recorded in the books of | |
| Particulars | petitioner |
| Machinery and equipment | $ 192,999.77 |
| Leasehold improvements | 7,388.92 |
| Furniture and fixtures | 3,313.27 |
| Machinery and equipment in process of | |
| construction or installation | 24,225.53 |
| $ 227,927.49 |
*1130 Petitioner's opening balance sheets showed the following assets and liabilities:
| Assets | |||
| Current assets: | |||
| Cash | $ 1,000.00 | ||
| Inventories: | |||
| Finished goods | $ 3,443.66 | ||
| Work in process | 63,671.22 | ||
| Raw materials | 44,306.71 | ||
| Inventory supplies and steel scrap | 8,393.88 | 119,815.47 | |
| $ 120,815.47 | |||
| Prepaid expenses | 1,649.22 | ||
| Plant and equipment | 227,927.49 | ||
| Patent application | 1.00 | ||
| $ 350,393.18 | |||
| Liabilities and net worth | |||
| Current liabilities: | |||
| Accounts payable -- trade | $ 113,921.32 | ||
| Accrued salaries and wages | 2,356.19 | ||
| Accrued miscellaneous taxes | 1,952.04 | ||
| Accrued sundry expenses | 635.32 | ||
| $ 118,864.87 | |||
| Capital stock and surplus: | |||
| Capital stock, $ 1 par value | $ 100,000.00 | ||
| Paid-in surplus | 131,528.31 | ||
| 231,528.31 | |||
| $ 350,393.18 |
*89 In organizing the proprietorship, Avildsen engaged the services of several keymen experienced in the drill manufacturing business, including Harry W. Delaney, who had been employed by Ford Motor Company for a number of years, then serving as assistant master mechanic; H. J. Kessler, superintendent of the small drill department of Latrobe; Earl Reinhart, a sales executive and vice president of United; Eric Andersen, also a vice president and treasurer of United; and George and Robert Avildsen, both vice presidents of United. Avildsen entered into 3-year employment contracts with Delaney and Kessler in August 1940, and a similar contract in January 1941 with Lawrence A. Shick, who was to serve as chief metallurgist and superintendent of the proprietorship's heat treatment department.
These employment contracts were also transferred to petitioner by Avildsen along with other contracts, including orders from the United States Army Air Corps for approximately $ 450,000 of twist drills and certificates of priority issued to the proprietorship in connection with such orders.
Twist drills are used for boring holes in metals, wood, and various other materials. They have a wide variety of*90 uses both in industry *1131 and in home workshops. They come in various sizes from a small fraction of an inch to several inches in diameter and in different types of steel, according to the uses for which they are intended. They are manufactured either from a round bar of steel, in which the flutes are cut by milling machines, or flat bars which are first twisted into drill shape and later machine finished. The flutes in the drill serve to carry off the waste cuttings and to permit the flow of a coolant down to the cutting point. The finishing of the drills requires several different grinding operations, tempering, straightening, and polishing.
The principal parts of a finished twist drill are identified as the flutes, lands, and web. In the better grades of drills the lands are ground off a fraction of an inch along their entire length just back of the cutting edge so as to give clearance between the drill and the material and prevent overheating. The web, or core, is the central body of the drill.
During the base period, flute cutting of round bars was the most common method of manufacturing twist drills. Under this method fluting is the most important and most costly*91 operation in the manufacturing process. The type of fluting mill most commonly used at the beginning of the base period was a single-spindle hand-operated machine. In these machines the round bars of steel, cut to proper drill lengths, called blanks, are placed in a chuck mounted on a movable carriage. The carriage is moved forward forcing the blanks into cutting or grinding tools independently mounted which form the flutes. The blank is revolved as it advances to give the proper spiral to the flutes and lands. During the base period about half of the output of small drills, referred to as jobber sizes, were fluted on these single-spindle, manually operated machines.
There were also in use during the base period some multiple-spindle fluting machines. They operated in much the same manner as the single-spindle machines except that there were from 2 to 5 chucks mounted on the same movable carriage with separate cutters for each spindle, so that all of the flutes were milled with a single forward movement of the carriage. The multiple-spindle machines were automatic or semiautomatic. The multiple-spindle, automatic machines were used principally for the smaller size drills during*92 the base period. Thereafter they were made in larger sizes to handle the larger drills. Some of the manufacturers continued to use the single-spindle, hand-operated machines during and after the base period.
At the time Avildsen left United in 1939 it was operating several different types of fluting machines, including single-spindle, manually operated, and multiple-spindle automatic machines. About 50 per *1132 cent of its output was fluted on the single-spindle, hand-operated machines.
United, in about 1938, operated 150 single-spindle, hand-operated machines and was also using about 35 Detroit automatics. The Detroit automatics did the clearance grinding as well as the fluting, all in one operation. Other automatics in use by United only milled the flutes. Both the automatics and the single-spindle, hand-operated machines were used for drills not over one-half inch in size while for the larger sizes the single-spindle, hand-operated machines were used. The jobber size drills were most in demand.
Under Delaney's direction the proprietorship undertook to build a multiple-spindle, hand-operated fluting machine. It first developed a 3-spindle machine experimentally. Later*93 it developed a 5-spindle machine which proved successful and was put into production early in 1941. These machines were not patented. The 5-spindle machine had practically the same basic mechanism as the single-spindle, hand-operated machine except that it fluted 5 drills at the same time. It was of original design and was unlike any other multiple-spindle machine then in use, although there were in operation other multiple-spindle fluting machines, as well as single and multiple automatics. Twenty-five of the 5-spindle, hand-operated machines were transferred to the petitioner by the proprietorship when it was organized in 1941. These machines were all designed for fluting small drills up to one-quarter of an inch. The cost of the 25 machines to the proprietorship was approximately $ 60,000.
One of the advantageous features of petitioner's 5-spindle machines was an adjustable screw-operated bushing block which made it possible to maintain accurate and uniform web thickness in each of the simultaneous flutings. This type of bushing adjustment had not previously been used in the fluting of drills.
Among the leading manufacturers of twist drills in the United States at the time*94 of petitioner's organization and during the base period, were:
United Drill & Tool Company
Union Twist Drill Company
Morse Twist Drill & Machine Company
National Twist Drill & Tool Company
Cleveland Twist Drill Company
Ampco Twist Drill Company and American Twist Drill Company were two of the smaller manufacturers of twist drills.The following table shows the type and approximate cost per unit of machines for fluting one-eighth of an inch twist drills in use by petitioner and the first five above-named companies in 1941: *1133
| Name of company | Type of machine | Approximate |
| cost | ||
| National Twist Drill & | Fully automatic multi-spindle milling | $ 4,600 |
| Tool Company | machines. | |
| Union Twist | Fully automatic single-spindle milling | 3,700 |
| Drill Company | machine. | |
| United Drill & | Detroit automatic | 1,700 |
| Tool Company | Hand-operated single-spindle | 1 |
| Ampco Twist | Hand-operated single-spindle milling | 1,300 |
| Drill Company | machine | |
| American Twist | Hand-operated single-spindle | 1 |
| Drill Company | Semiautomatic single-spindle | 1,800 |
| Petitioner | Hand-operated 5-spindle milling machine | 2,600 |
With all types of fluting machines there was an increase in*95 cost for the larger units required for fluting drills of larger sizes.
With the fully automatic machines, blanks were fed into the chucks from a hopper and were returned to another hopper completely fluted and, with some of the machines, ground for clearance. All that was required of the operators was to attend the hopper and see that the machines functioned properly. With the hand-operated models, such as petitioner's 5-spindle machines, the operators had to place the blanks in the chucks and remove them by hand. Fluting machines were set up in groups, or banks, of the proper number to be serviced by one operator. They also required a "set-up" man whose duty was to see that they were properly adjusted. Usually, 1 set-up man could serve the machines of 2 operators. One operator could handle 12 to 20 of the fully automatic machines, depending upon the size of the drills, while with the single-spindle, hand-operated and semiautomatic, 1 operator was required for 8 to 12 machines. Skilled laborers were not required for operators, although a trained operator could increase the production. The set-up men were skilled, or semiskilled labor. They required a 2 weeks' period, or more, *96 for training.
The proprietorship, and petitioner, used all female labor as fluting machine operators. At one time as much as 85 per cent of petitioner's employees were women. Most of its equipment was especially designed or adapted for women operators. For manufacturing up to one-eighth inch drills 1 operator was assigned to 4 machines and 1 setup girl to 8 machines. Petitioner's employees numbered about 200 at the start but increased to over 2,000 at the peak of the war period.
Petitioner's 5-spindle machines were capable of producing about 125 one-eighth inch size drills per hour per machine at full efficiency without down-time, or about 106 per hour per machine in practical operation. The production rate was about 100 per hour for fully automatic, 2-spindle machines used by National Twist Drill & Tool Company; 50 per hour for the automatic 1-spindle machines used by *1134 Union Twist Drill & Tool Company; 30 per hour for the Detroit automatics, which also did the clearing operation; about 50 per hour for the semiautomatics; and 20 to 25 per hour for the single-spindle, hand-operated machines.
The proprietorship also developed an improved clearance grinding machine which*97 was easy to operate and was especially designed for women operators. They cost approximately $ 2,000 each to build. Petitioner acquired 12 of these machines from the proprietorship at the time of its organization. It built 24 additional machines at a cost of approximately $ 2,400 each. Some of petitioner's competitors used converted fluting machines for clearance grinding. Female labor was used by some of petitioner's competitors for a part and by others for all of their fluting and clearance grinding operations.
Point grinding is another important feature of drill manufacturing. For this operation the proprietorship and petitioner used Sellers point grinding machines. These machines were built by the proprietorship under an arrangement which Avildsen made with Sellers Manufacturing Company. Twenty-two of them were transferred to petitioner at the time of its organization.
The proprietorship also put into operation the "roll forged" method of manufacturing drills which had been developed by Delaney while in the employment of the Ford Motor Company. Petitioner was the first manufacturer to produce, for the market, drills manufactured by this process.
When petitioner first *98 began operations it manufactured only jobber drills from one-sixteenth to one-half inch. Its plant was equipped especially for the manufacture of these sizes. Later it began manufacturing the larger sizes and also a substantial quantity of reamers.
The proprietorship was in full operation by July 1941, and was then manufacturing drills under contracts with the United States Air Force. These contracts had been obtained under competitive bidding. Most of petitioner's production of drills during the war years went directly to Government agencies or to contractors with Government priorities. Sales could be made only under war production priorities.
Petitioner's shipments of drills under Government contracts with the Air Corps and other Government agencies and its total shipments for the years 1942, 1943, and 1944, were as follows:
| Year | Government | Total contracts |
| contracts | ||
| June 30, 1942 | $ 2,127,498.18 | $ 3,749,464.33 |
| June 30, 1943 | 7,977,761.66 | 11,488,184.06 |
| June 30, 1944 | 5,375,325.59 | 8,523,228.11 |
*1135 The following table shows, in percentage figures, the sales of United to jobbers, consumers, and Government agencies for the years 1941 to 1945, inclusive:
| Sales to | Sales to | Sales to | |
| Years | jobbers | consumers | Government |
| agencies | |||
| 1941 | 51 | 1 | 1 |
| 1942 | 49 | 26.41 | 14.59 |
| 1943 | 53 | 25.45 | 21.55 |
| 1944 | 62 | 27.26 | 10.74 |
| 1945 | 73 | 1 | 1 |
Under wartime conditions petitioner operated its plant 24 hours a day with 3 shifts of 8 hours each.
In its sales of drills petitioner, along with most of the industry, followed a standard list price. Various discounts were allowed from the list prices, depending upon the type of drills and the customers. Generally an extra 20 per cent discount was given to jobbers and distributors over the prices to consumers. Petitioner's prices, as listed in its catalogs, were comparable to those of other leading twist drill manufacturers. Discounts allowed on Government contracts by petitioner were equal to or greater than those given to jobbers and distributors.
According to the records of the Metal Cutting Tool Institute, the members reporting to the Institute had the following amounts of aggregate net sales of twist drills and reamers during the years 1937 to 1946, inclusive:
| Year | Net sales |
| 1937 | $ 18,386,000 |
| 1938 | 8,897,000 |
| 1939 | 14,272,000 |
| 1940 | 22,417,000 |
| 1941 | 55,152,000 |
| 1942 | $ 81,539,000 |
| 1943 | 87,828,000 |
| 1944 | 58,713,000 |
| 1945 | 49,320,000 |
| 1946 | 41,690,000 |
The following table shows the net sales, gross profits, comparative net income, and comparative invested*100 capital of the petitioner and the aggregate of five other twist drill manufacturers, 1 petitioner's data being for the fiscal years ended June 30, 1942 to 1949, inclusive, the remaining data being for the years 1936 to 1945, inclusive.
*1136
| PETITIONER | |||||
| Comparative | Comparative | ||||
| Year | Net sales | Gross profits | net income 1 | invested | |
| (or loss) | capital 2 | ||||
| 7/16/41 to: | 6/30/42 | $ 3,175,372 | $ 1,253,244 | $ 721,756 | $ 1,212,673 |
| 6/30/43 | 10,492,049 | 2,832,905 | 1,493,877 | 2,066,485 | |
| 6/30/44 | 8,221,339 | 2,379,699 | 363,160 | 2,805,044 | |
| 6/30/45 | 6,304,080 | 2,167,514 | 122,441 | 3,060,117 | |
| 6/30/46 | 4,524,722 | 1,809,599 | 408,533 | 2,718,618 | |
| 6/30/47 | 5,191,681 | 1,830,495 | 212,171 | 4,160,425 | |
| 6/30/48 | 4,330,411 | 1,464,082 | 232,670 | 3,755,417 | |
| 6/30/49 | 4,008,849 | 1,443,433 | 16,030 | 3,424,852 | |
| AGGREGATE OF THE FIVE COMPANIES | |||||
| 1936 | $ 11,108,478 | $ 4,218,521 | $ 1,511,650 | $ 13,976,232 | |
| 1937 | 13,644,570 | 6,306,828 | 2,502,711 | 14,679,014 | |
| 1938 | 6,922,182 | 2,956,971 | 316,899 | 14,750,024 | |
| 1939 | 11,432,925 | 4,777,535 | 1,631,682 | 11,810,605 | |
| 1940 | 19,638,647 | 9,660,048 | 5,018,906 | 13,065,264 | |
| 1941 | 40,767,749 | 22,103,520 | 15,333,150 | 16,287,426 | |
| 1942 | 50,111,975 | 21,910,674 | 12,754,197 | 21,765,864 | |
| 1943 | 49,689,432 | 18,563,641 | 10,334,883 | 24,943,133 | |
| 1944 | 34,207,769 | 13,342,195 | 8,888,940 | 24,166,913 | |
| 1945 | 29,645,622 | 12,020,413 | 5,284,747 | 20,755,253 |
The following table shows the ratios of gross profits to net sales, comparative net income to sales, and comparative net income to comparative invested capital, for the five above-named companies for the years 1936 through 1945, and for petitioner for the fiscal years ending June 30, 1942 to 1949, inclusive.
| Comparative net | ||||||
| Gross profits | Comparative net | income to | ||||
| to net sales | income to net | comparative | ||||
| Year | sales | invested capital | ||||
| 5 Cos. | Petr. | 5 Cos. | Petr. | 5 Cos. | Petr. | |
| 1936 | 37.98 | 13.61 | 10.82 | |||
| 1937 | 46.22 | 18.34 | 17.05 | |||
| 1938 | 42.72 | 4.58 | 2.15 | |||
| 1939 | 41.79 | 14.27 | 13.82 | |||
| 1940 | 49.19 | 25.56 | 38.41 | |||
| 1941 | 54.22 | 37.61 | 94.14 | |||
| 1942 | 43.72 | 39.47 | 25.45 | 22.73 | 58.60 | 59.52 |
| 1943 | 37.36 | 27.00 | 20.80 | 14.24 | 41.43 | 72.29 |
| 1944 | 39.00 | 28.95 | 25.99 | 4.42 | 36.78 | 12.95 |
| 1945 | 40.55 | 34.38 | 17.83 | 1.94 | 25.46 | 4.00 |
| 1946 | 39.99 | 9.03 | 15.03 | |||
| 1947 | 35.26 | 4.09 | 5.10 | |||
| 1948 | 33.81 | 5.37 | 6.20 | |||
| 1949 | 36.01 | 0.40 | 0.47 |
*102 Since 1945 several twist drill manufacturers located in the United States and in Europe have purchased from petitioner and put into operation a number of multiple-spindle fluting mills, clearance *1137 grinders, and other equipment. Such purchases amounted to over $ 428,000 during the period 1946-1954.
Petitioner's net fixed assets, including machines and equipment. and its total assets covered by certificates of necessity, for the years 1942 to 1945, inclusive, were as follows:
| Net fixed assets | ||
| Year | (after reserves) | Total assets |
| June 30, 1942 | $ 1,021,384.49 | $ 1,078,217.81 |
| June 30, 1943 | 1,748,627.13 | 2,081,713.46 |
| June 30, 1944 | 1,648,336.18 | 1,881,530.26 |
| June 30, 1945 | 1,083,751.39 | 1,829,541.81 |
The assets covered by the certificates of necessity were depreciated on a 20 per cent basis (sec. 124, Revenue Act of 1939) in petitioner's tax returns.
Avildsen devoted his full time to the business from the date of the organization of the proprietorship and, with the other keymen whom he employed, worked long hours to build up the business. Before leaving United he received as compensation from that company a salary of $ 35,000 per year plus a bonus. His total*103 compensation amounted to $ 67,729.96 in 1937, $ 58,765.72 in 1938, and $ 35,660.57 in 1939. For the years 1942 to 1946, inclusive, his compensation from petitioner, after adjustments by the revenue agent, was as follows:
| Fiscal year ended | |
| June 30 | Amount |
| 1942 | $ 98,507.67 |
| 1943 | 98,501.50 |
| 1944 | 64,443.62 |
| 1945 | 57,824.02 |
| 1946 | 56,644.12 |
Petitioner's excess profits net income, excess profits credit, based on invested capital, and excess profits tax liability, as determined by the respondent, for each of the fiscal years involved, 1942, 1943, 1944, and 1946, are as follows:
| Excess profits | Excess profits | Excess profits | |
| Year | net income | credit | tax liability |
| 1942 | 1 $ 748,050.21 | $ 48,057.58 | $ 355,749.19 |
| 1943 | 1,459,035.87 | 146,949.36 | 971,269.70 |
| 1944 | 346,633.07 | 189,681.75 | 138,081.66 |
| 1946 | 433,485.60 | 183,216.82 | 103,559.14 |
A deficiency for the taxable year 1943 of $ 217,356.46 has been determined by reason of a deferment of excess profits tax under section 710 (a) (5) of the Internal Revenue Code. All of the above-shown amounts of excess profits tax liability are in controversy.
*1138 *104 The business of the taxpayer for the taxable years in question was of a class in which intangible assets not includible in invested capital made important contributions to income.
The excess profits credit based on invested capital is an inadequate standard for determining excess profits for the fiscal year ending June 30, 1942, but is not an inadequate standard for the fiscal years ending June 30, 1943, 1944, and 1946.
A fair and just amount representing normal earnings to be used as a constructive average base period net income for the fiscal year ending June 30, 1942, is $ 123,000.
OPINION.
The petitioner seeks excess profits tax relief under section 722 (c), Internal Revenue Code of 1939. Not having come into existence until after 1939, it is not entitled to use excess profits credit based on income under section 713. It contends that its excess profits credit, based on invested capital, computed under section 714, is an inadequate standard of normal earnings because its business is of a class in which intangible assets, not includible in invested capital under section 718, made important contributions to income (sec. 722 (c) (1)) and its invested capital was abnormally low *105 (sec. 722 (c) (3)). 2
A corporation is said to come within the "class" referred to in section 722 (c) (1) above "if the nature of the taxpayer's business function, the character of its organization, or the methods it employs in operation are such that intangible assets of the character in question*106 make important contributions to income, * * *." (Bulletin on Section 722, as amended by E. P. C. 35.)
The petitioner lists as among the intangible assets not includible in invested capital (1) the goodwill or going concern value of the business which it acquired from the proprietorship; (2) the secret processes or the unique method of manufacturing twist drills on its 5-spindle fluting machines, acquired from the proprietorship, and the exclusive right to use, manufacture, and sell such machines; (3) the employment contracts with its key personnel; (4) the customers' lists; (5) the production plan embodying technique and machinery for the employment of female labor; and (6) the certificates of *1139 priority which Avildsen transferred to the petitioner at the time of its organization.
Respondent concedes on brief that at the time petitioner took over the business from the proprietorship, the business had already achieved full development. We think it is clear from the evidence that the business had a substantial going concern value when it was taken over by petitioner, particularly when interrelated with the availability of the continued services of Avildsen and his selected*107 key personnel. We think that the strongest contributing factor to petitioner's success was Avildsen himself. His experience in the twist drill manufacturing business, his knowledge of the industry generally, his organization ability, his comprehensive knowledge of the problems of the particular business, and his contacts with outlet sources were vital factors in petitioner's bid for a footing in the industry. He was the organizer, dominant personality, and sparkplug of the petitioner. Under the principles announced in Danco Co., 14 T. C. 276, 283-285 (1950), Avildsen's important contributions to the business through his own attributes and qualifications were in themselves sufficient to qualify petitioner under section 722 (c) (1). See also Jackson-Raymond Co., 23 T. C. 826 (1955).
In other words the outstanding capacity of Avildsen himself (not to mention capability of the key men who were brought into the company under pre-existing employment contracts) were intangible assets not included in invested capital which clearly made important contributions to income. Correlating this with the taking over of a ready-made*108 business with going concern value merely gives further emphasis to the significance of these intangible assets as an integrated whole.
In the light of the conclusions indicated above, there is no occasion for us to consider whether or not the remaining factors listed by petitioner are intangible assets or whether they made important contributions to income.
Likewise, since we hold that petitioner is qualified under section 722 (c) (1) it is not necessary for us to consider whether it also qualifies under 722 (c) (3).
Respondent, relying upon Blum Folding Paper Box Co., 4 T. C. 795 (1945), urges on brief that we are barred from considering the limited issue of goodwill or going concern value on the theory that the issue was not administratively presented. While the precise words "goodwill" or "going concern value" were not used, our examination of the statement made a part of the application for relief for the year ending June 30, 1942 (and incorporated by reference in the applications for the other years before us), satisfies us that respondent was sufficiently apprised of the basis of petitioner's claim and the facts on which it relied in relation *109 to this issue. See Trunz, Inc., 15 T. C. 99, 105*1140 (1950); Morgan Construction Co., 242">23 T. C. 242, 254 (1954). Moreover, as indicated above, we hold that petitioner has qualified for relief under the principles of Danco Co., supra, so that assuming, arguendo, that respondent's position may have possible merit on a segregated issue involving only goodwill or going concern value, our ultimate determination would not be affected thereby.
Respondent makes the further contention that petitioner is a "war baby" and therefore cannot qualify for relief.
We think it is quite apparent upon the record that petitioner's business was essentially a peacetime activity, devoted to the war effort, however, as were many peacetime industries, because of the exigencies of the war period. We find nothing in the law or the decisions interpreting it which warrant our denying relief on this ground. The effect of rearmament and European war conditions in the latter part of 1939 upon any reconstruction of earnings presents, of course, an entirely different question.
Petitioner asserts, and respondent *110 denies, that the excess profits credit based on invested capital is an inadequate standard for determining excess profits for each of the fiscal years in issue. It is our view that such a standard is inadequate for the fiscal year ending June 30, 1942, but is adequate for the remaining years in issue. The respective invested capital credits for the years before us are set forth in our findings. Our views will be apparent from our reconstruction.
The record contains elaborate statistical data, including various ratios and comparatives, and there is much in the way of opinion evidence. The briefs present theories which the parties would have us apply to their respective views of the facts. We think it apparent that the respondent's approach to reconstruction (which would deny all relief) is much too low, while petitioner's proposed reconstruction of $ 264,372 is much too high. There is, however, sufficient information in the record to enable us to apply our own judgment, although we must recognize that in this, as in many section 722 cases, we cannot hope to be precise because of the many imponderables to be considered.
We, of course, have given thought to the reconstruction of*111 sales and profits for the year 1939 under base period conditions and to backcasting techniques to be applied in order to reach average constructive earnings for the entire base period. The data and opinion evidence submitted has been helpful in reaching our ultimate conclusions, but no single factor has been determinative. We have, in our reconstruction, given the weight we deemed appropriate to respondent's contention that regard be given to the enhancement of demand in the latter part of 1939 under the stimulus of rearmament and war in Europe. We have, on the other hand, made no adjustment under the variable credit rule because respondent concedes that the business *1141 had reached the stage of full development at the time petitioner took over the proprietorship.
After weighing all of the factors involved, it is our judgment that $ 123,000 is a fair and just amount of normal earnings to be used as a constructive average base period net income in determining excess profits for the fiscal year ending June 30, 1942. We would have found a like amount for each of the other years before us, but there is no occasion for us to do so because it is apparent from our discussion that*112 the excess profits credit for those years was not an inadequate standard.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. Not available.↩
1. Not available.↩
1. United Drill & Tool Company, Union Twist Drill Company, Morse Twist Drill & Machine Company, Ampco Twist Drill Company, and American Twist Drill Company.↩
1. Comparative net income is taxable net income (net income for declared value excess-profits tax purposes) with certain adjustments, such as exclusion of (1) domestic dividends, (2) capital gain (or loss), (3) all interest on Federal, State, and municipal obligations, and (4) declared value excess-profits tax; it is roughly comparable with excess profits net income currently reported.↩
2. Comparative invested capital includes net worth, surplus reserves and bonds, notes and mortgages payable.↩
1. Annualized from $ 717,308.42 for computation of tax.↩
2. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
(c) Invested Capital Corporations, Etc. -- 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, not entitled to use the excess profits credit based on income pursuant to section 713, if the excess profits credit based on invested capital is an inadequate standard for determining excess profits, because --
(1) the business of the taxpayer is of a class in which intangible asets not includible in invested capital under section 718 make important contributions to income,
* * * *
(3) the invested capital of the taxpayer is abnormally low. * * *↩