*95 Decision will be entered for the respondent.
Held, from the evidence, that petitioner, which commenced business during the base period, failed to establish assumed earnings under the push-back rule of an amount sufficient, under reconstruction, to result in an excess profits credit in excess of the amount allowed by the invested capital method without relief under section 722 of the Internal Revenue Code.
*1067 This proceeding involves a deficiency of $ 1,797.08 in excess profits tax for the year 1941, assessment and collection of which was waived by the petitioner, and disallowances of applications for relief under section 722 of the Internal Revenue Code for the years 1942, *96 1943, and 1944. The issue is whether petitioner is entitled to relief under the provisions of section 722 (b) (4) of the Code. The excess profits tax returns of the petitioner for the taxable years were filed with the collector for the district of Georgia. The facts set forth in a stipulation of facts of the parties are found as agreed to therein. Material parts thereof will be included in connection with facts found from other evidence.
FINDINGS OF FACT.
Petitioner, a Georgia corporation, with its principal office at La Grange, Georgia, was organized on or about December 28, 1936, by Callaway Mills, a corporation, hereinafter referred to as "Callaway." Petitioner kept its books and filed its income and excess profits tax returns on the basis of a calendar year and the accrual method of accounting. The business of petitioner was acquired, effective January *1068 2, 1946, by Industrial Suppliers, Inc., a corporation, all of whose stock is owned by O. F. Nixon, Jr., and his wife.
At the time of organization of petitioner, Callaway was operating eight textile mills in La Grange, Georgia, having a total of about 140,000 spindles, and maintained a supply room at each of its plants. *97 It was a leader in and a representative member of the cotton textile industry. Petitioner was organized by Callaway to operate a centrally located warehouse from which to obtain supplies for its mills. Callaway believed that a consolidation of its supply facilities would result in savings of supplies and reduce inventories.
The majority of the stock of Callaway was held by Cason Callaway and Fuller Callaway, who were members of a family. All of the stock of petitioner was issued to Callaway. About January 1937 Callaway distributed the stock to its stockholders. There was not at any time important thereafter a change in the majority stockholdings of Callaway.
Promptly after its incorporation petitioner entered into an agreement with Callaway to operate for a fixed fee a centrally located supply room, for storing, handling, and delivering material. Thereafter the supplies held by Callaway at each of its plants were moved to a warehouse of petitioner. Callaway transferred no personnel to petitioner in connection with the plan other than handlers of material. The fixed charge in 1937 for the services of petitioner under the agreement was $ 400 a month. The fee, effective January*98 1, 1939, was increased to 5 per cent of the invoice price of material with a minimum of $ 1,666.66 a month. The fee was increased because the amount was unprofitable to petitioner and was not sufficient to cover petitioner's cost of performing the service. Petitioner was not prepared to furnish service under the plan until the latter part of 1937.
The service contract was terminated April 30, 1939, previous to which the supplies were moved back to the plants of Callaway and it resumed its former practice of maintaining a supply room at each of its plants. The material handled by petitioner under the agreement was at all times owned by Callaway.
Petitioner received the following amount of gross income under the agreement:
| 1937 | $ 422.85 |
| 1938 | 19,938.31 |
| 1939 | 6,666.64 |
In addition to servicing supplies for Callaway for a fixed fee, petitioner made sales of material to Callaway from its stock. It did not begin business with the public on a substantial basis until September or October, 1937.
Petitioner sold supplies for textile mills and other types of industries, *1069 such as foundries and road and building contractors. The supplies included coal, loom supplies, paint, *99 roofing, roofing compound, general hardware, and other building supplies. In 1938 and 1939 it sold supplies for laundries, including soda ash and caustic soda.
At the time of its organization there was no source of textile mill supplies closer to La Grange than Atlanta, Georgia, and Birmingham and Montgomery, Alabama. Petitioner operated in a territory within a radius of about 100 miles of La Grange, an area in which there were about 4,000,000 cotton spindles.
The president and chief executive officer of petitioner from January 1937 until June 28, 1939, was Lee Talman, who had no prior experience in the mill supply and textile business. The original salesmen of petitioner had no prior experience in the business in which petitioner was engaged. One of the salesmen had some experience in the manufacture of supplies for textile mills.
During the summers of 1926, 1927, and 1928 while attending high school, O. F. Nixon, Jr., worked at various jobs at the Newnan Cotton Mills, Newnan, Georgia, learning the textile business. About August 1928 he commenced to study textile engineering at "Georgia Tech." The course he pursued consisted of working one month and attending school the next*100 month. Nixon spent the working months at a plant of Callaway. He entered the employ of Callaway on a full time basis after completing four years of a five-year course. For about three years he was in charge of the sample mill, which made samples for customers, and later was appointed assistant superintendent of one of the plants, a position he held for about one or one and one-half years. He was then appointed assistant technical superintendent of the technical department of the mill which prepared all manufacturing specifications. He held that position until June 15, 1937, when he entered the employ of petitioner. Nixon was elected vice president of petitioner in October 1938 and had charge of sales. He became its president on July 1, 1939, and as such had full charge of operations. Prior to the time Nixon was elected president he was at all times connected with the sales department of petitioner, and he spent about 75 per cent of his time traveling in the territory assigned to him and working with other salesmen. Nixon has no financial interest in the outcome of this proceeding.
After July 1, 1939, petitioner decided to discontinue the sale of certain of its lines and specialize*101 in the handling of all supplies for manufacturing plants in the textile industry and adopted a policy of handling only what it regarded as the best of competitive brands of the same article. The margin of profit on the items to be discontinued was less than on the materials to be retained for sale in the business. Thereafter it commenced to put the plan into effect and most of the eliminations were made by the close of 1939. Some lines *1070 of supplies were discarded in 1940 and a few in 1941. Petitioner had a net profit each month after the change was made. Petitioner employed two salesmen who had had training in textile business to replace salesmen lacking such experience before their employment by petitioner. One of the new salesmen was employed in October 1939 and the other one in March 1940. Petitioner had the exclusive territory for some of its major items of material. During July 1939 petitioner eliminated some unprofitable "red tape" and paper work in its office and discontinued the use of "IBM" equipment which it had been using at a cost of several hundred dollars a month. Nixon knew of no other business which was a complete source of supply for textile manufacturing*102 plants.
One or two of petitioner's salesmen devoted all of their time to the sale of laundry supplies. Sales of supplies to laundries were not profitable and that branch of petitioner's business was discontinued in January or February, 1940.
In 1942 petitioner made sales to drug companies, building contractors, a hardware store, a bus company, an automobile agency, and Troup County, Georgia, none of which was a member of the textile industry.
The first catalogue of articles petitioner sold under the new plan of operation was published in 1941. The chief reason for not publishing a catalogue prior thereto was failure to make earlier decisions on the articles to be stocked for sale.
In or prior to August 1939, petitioner was the successful bidder to supply and install furniture and fixtures, including seats, for the courthouse and county building of Troup County, Georgia. The cost to petitioner of the articles was $ 18,012.72, for which there was a debit balance of $ 3,358.42 on the books of petitioner at the close of August 1939, and the sales price was $ 18,724.74, which amount is reflected in the sales account of petitioner for October 1939, the month in which the contract was*103 completed. The sale was an unusual transaction for the business in which petitioner was engaged. The transaction assisted petitioner in obtaining an agreement to handle the Shaw-Walker line of office furniture, which is a good class of articles for the business in which petitioner was engaged. Petitioner has at all times since then sold the furniture to textile plants and to members of other industries.
Nixon was in the Navy from June 1944 until November 1945. His position with petitioner was filled during his absence by John Dodd, an automobile dealer, who tried to hold the business of petitioner together. At some undisclosed time two of petitioner's best salesmen left its employ for Army service.
Except for Callaway, petitioner had no customers when it was organized. To obtain customers it was necessary for petitioner to divert *1071 them from their existing sources of supply. Many of the articles sold by petitioner were consumable goods. When it obtained a customer it generally obtained orders from it thereafter for a substantial part of its requirements.
The net sales and net operating income or loss of petitioner for the years 1937 to 1945, inclusive, and excess *104 profits net income or loss during the base period and like income, computed under section 711 of the Code, for subsequent years were as follows:
| Year | Net sales 1 | Net income | Excess profits |
| (or loss) | net income | ||
| 1937 | $ 209,747.82 | ($ 6,274.18) | ($ 6,274.18) |
| 1938 | 290,709.40 | (12,149.91) | (12,149.91) |
| 1939 | 2 420,561.15 | 4,993.09 | 3,508.75 |
| 1940 | 432,788.45 | 10,819.81 | 10,819.81 |
| 1941 | 823,316.37 | 37,489.88 | 37,503.95 |
| 1942 | 758,406.91 | 43,124.95 | 43,164.88 |
| 1943 | 617,840.41 | 26,120.32 | 25,735.94 |
| 1944 | 654,559.76 | 27,576.61 | 27,576.61 |
| 1945 | 634,274.29 | 25,741.90 | 25,741.90 |
Petitioner received selling commissions on sales of material which was shipped directly to the consumer by the manufacturer. Only the sales commission earned in the transaction was entered in petitioner's books. Most of the sales to Callaway were from stock. One of the policies adopted by Nixon when he became president of petitioner was to make more sales from stock and thereafter sales from that source increased.
Total expenses, *105 compensation of officers, and salaries, wages and commissions incurred by petitioner in the years 1937, 1938, and 1939 and 1940 were as follows:
| 1937 | 1938 | 1939 | 1940 | |
| Total expenses | $ 27,653.42 | $ 74,053.13 | $ 63,573.62 | $ 55,671.00 |
| Compensation of officers | 4,500.00 | 15,724.96 | 10,999.98 | 7,800.00 |
| Salaries, wages and | ||||
| commissions | 7,995.41 | 27,869.71 | 23,851.89 | 20,856.08 |
The net sales of petitioner to Callaway during the years 1937 to 1945, inclusive, except 1940 and 1942, for which years the amounts are not available, were as follows:
| Year | Net sales |
| 1937 | $ 180,600.06 |
| 1938 | 180,013.01 |
| 1939 | 177,742.47 |
| 1941 | 341,282.38 |
| 1943 | 140,786.71 |
| 1944 | 152,753.99 |
| 1945 | 184,380.43 |
*1072 After the servicing agreement was terminated, Callaway continued to make purchases of supplies from petitioner. Petitioner was favored by Callaway in the purchase of supplies for its plants and petitioner was its source of supply for a large percentage of its requirements. The amount of net sales to Callaway in 1939 includes sales before and after the servicing agreement was terminated. The sales to Callaway were handled by the employees in the office of petitioner and no commission*106 was paid in connection with the orders. No preferential discount was given on sales to Callaway. Callaway made its purchases from petitioner as it needed supplies.
Spindles in use are a better index of activity in the textile industry than the volume of cotton consumed. The best index of textile mill activity and their requirement for supplies is reflected by the spindle hours operated in cotton growing states. Using the spindle hours operated by textile mills in the cotton growing states for 1939 as 100 per cent, the index of those activities for the base period years would be as follows:
| Year | Per cent |
| 1936 | 97.7 |
| 1937 | 102.2 |
| 1938 | 82.9 |
| 1939 | 100.0 |
The bales of cotton consumed in Georgia and petitioner's net sales per hundred bales of cotton consumed in that state were as follows during the quarterly periods of the years 1937 to 1939, inclusive:
| Quarters | 1937 | 1938 | 1939 |
| 1 | 414,701 | 250,139 | 353,665 |
| 2 | 407,937 | 232,446 | 344,977 |
| 3 | 343,236 | 289,523 | 354,753 |
| 4 | 287,305 | 338,941 | 419,380 |
| Total | 1,453,179 | 1,111,049 | 1,472.775 |
| Petitioner's net sales per hundred bales of cotton consumed | |||
| Quarters | 1937 | 1938 | 1939 |
| 1 | $ 0.46 | $ 33.24 | $ 26.23 |
| 2 | 2.17 | 29.11 | 26.50 |
| 3 | 22.60 | 22.27 | 30.43 |
| 4 | 42.25 | 22.26 | 30.19 |
*107 The active cotton spindle hours in cotton growing states, and petitioner's net sales expressed in dollars and per thousand cotton spindle hours, by quarters, for base period years were as follows: *1073
| Active spindle hours | |||
| Quarters | 1937 | 1938 | 1939 |
| 1 | 20,169,539 | 14,021,623 | 18,084,222 |
| 2 | 20,176,650 | 12,946,026 | 17,336.603 |
| 3 | 18,857,270 | 16,101,710 | 17,505,925 |
| 4 | 15,646,908 | 17,226,083 | 19,816,447 |
| Totals | 74,850,367 | 60,295,442 | 72,743,197 |
| Petitioner's net sales | |||
| Quarters | 1937 1 | 1938 1 | 1939 |
| 1 | $ 1,910.75 | $ 83,136.33 | $ 92,753.87 |
| 2 | 8,854.17 | 67,668.65 | 93,241.69 |
| 3 | 77,582.95 | 64,469.40 | 107,949.21 |
| 4 | 121,399.95 | 75,435.02 | 2 126,616.38 |
| Totals | 3 $ 209,747.82 | 3 $ 290,709.40 | 3 $ 420,561.15 |
| Petitioner's net sales per thousand spindle hours | |||
| Quarters | 1937 | 1938 | 1939 |
| 1 | $ 0.09 | $ 5.93 | $ 5.13 |
| 2 | .44 | 5.23 | 5.38 |
| 3 | 4.11 | 4.00 | 6.17 |
| 4 | 7.76 | 4.38 | 6.39 |
*108 The method which results in the lesser excess profits tax of petitioner for each of the taxable years is the invested capital method, prescribed in section 714 of the Code.
The excess profits tax liability of petitioner for the years 1940 to 1945, inclusive, as determined by the respondent without application of section 722, is as follows:
| Excess profits | |
| Year | tax liability |
| 1940 | None |
| 1941 | 1 $ 4,013.79 |
| 1942 | 17,836.44 |
| 1943 | 3,764.48 |
| 1944 | 753.19 |
| 1945 | None |
Petitioner's excess profits credit under the provisions of section 714 of the Code, without the application of section 722, for the calendar years 1940 to 1945, inclusive, is as follows:
| 1940 | $ 16,534.78 |
| 1941 | 1 15,321.00 |
| 1942 | 16,144.58 |
| 1943 | 16,553.19 |
| 1944 | 16,783.78 |
| 1945 | 16,572.03 |
*1074 The applications for relief which petitioner filed on Form 991 for the years 1941, 1943, and 1944 asked for constructive average base period net income of $ 40,000. Attached to the application for 1941 is an exhibit*109 on which are listed the names of 15 "new customers" secured in 1939 and sales, if any, made to them in that year and 1940 and 1941. Total sales to the list of alleged "new customers" are set forth therein as $ 86,870.01 in 1939, $ 112,868.09 in 1940 and $ 260,375.04 in 1941. According to the exhibit, no sales were made to three of the "new customers" until 1941, and to one until 1940. The purchases of one of the concerns were less than $ 100 in 1939 and 1941, none in 1940. Another concern purchased less than $ 200 of supplies each year.
OPINION.
Petitioner is claiming relief under subsections (a) and (b) (4) 1 of section 722 of the Internal Revenue Code, upon the ground that it commenced business during the base period and changed the character of its business in 1939 by a change in operation or management and a difference in the product furnished.
*110 The respondent concedes that petitioner commenced business during the base period and to that extent complies with one of the conditions for application of subsection (b) (4) but denies that petitioner changed the character of its business as alleged. The disagreement of the parties need not be decided, since, even assuming that petitioner has complied with both conditions, the petitioner, for reasons hereinafter set forth, has not sustained its burden under the statute which requires that it establish that the tax computed without the benefit of *1075 section 722 results in an excessive and discriminatory tax, and also establish a fair and just amount representing normal earnings to be used as a constructive average base period net income. Therefore, it is not entitled to relief under section 722 (b) (4).
Petitioner, having commenced business during the base period, is entitled to the 2-year push-back rule in subsection (b) (4). We have held that the function of the rule "is to establish a figure which is assumed to be the maximum amount which would have been earned by the taxpayer in its last base period year, if it had commenced business 2 years before it did," and that*111 the assumed figure is then used in the reconstruction of the taxpayer's average base period net income. Del Mar Turf Club, 16 T. C. 749, 766. Petitioner had the burden of proof under the rule. Singer Bros., Inc., 15 T. C. 683, 692. We said in Pabst Air Conditioning Corporation, 14 T. C. 427, 436, that "persuasive reasons, supported by adequate evidence, must be shown in order to reconstruct base period net income under the 'push back' rule."
Petitioner contends in its opening brief that if it had commenced business and made the changes 2 years earlier than it did, it would have reached a level of earnings of at least $ 45,000 in 1939. The amount was reduced to at least $ 40,000 in its reply brief. Respondent's position in the matter of earnings during the base period is that petitioner has failed to prove that it did not reach by the close of 1939 the level of earnings it would have reached if it had commenced business 2 years before it did.
The only direct evidence in the record on the matter of the earning level petitioner would have reached by the end of the base period if it had commenced*112 business 2 years earlier than it did is testimony of Nixon, the only witness for petitioner at the hearing. He testified that he believed that petitioner would have reached a level of earnings of from $ 45,000 to $ 50,000 by December 31, 1939, if it had commenced business and made the changes described by him 2 years earlier than it did. More than the mere conclusion of the witness is necessary to establish the ultimate fact we are required to find. 7- Up Fort Worth Co., 8 T. C. 52, 63; Pabst Air Conditioning Corporation, supra; Powell-Hackney Grocery Co., 1484">17 T. C. 1484; Farmers Creamery Co. of Fredericksburg, Va., 18 T. C. 241. Moreover, the opinion expressed by the witness was not based upon all of the facts of record and to that extent lacks a proper foundation. Avey Drilling Machine Co., 1281">16 T. C. 1281, 1299.
In its applications to the respondent for relief, petitioner claimed constructive average base period net income of $ 40,000, based upon assumed sales of $ 750,000 in 1939 and profit of about $ 47,000. The sales figure was*113 reached by assuming that if it had commenced business 2 years earlier than it did, sales in 1939 would have exceeded *1076 actual sales by the average of the increase of actual sales in 1938 and 1939 over the preceding year of each, but as the method used exceeded a point beyond which the business could not be expanded and operated at a profit, the figure was reduced to $ 750,000. Such a procedure is outside of the push-back rule. Singer Bros., Inc., supra, p. 693. Actual sales of petitioner in 1939 were only $ 420,561.15 or about 56 per cent of $ 750,000 and its net operating income was $ 4,993.09 or only about one-eighth of $ 40,000. Callaway was established as a customer as soon as petitioner commenced to operate. Sales to it in 1939 were about 42 per cent of total sales.
The statute prohibits consideration of post-1939 events to determine normal earnings of base period years. Section 722(a); Clinton Carpet Co., 14 T. C. 581, 587; Matheson Co., 16 T. C. 478, 488; General Metalware Co., 17 T. C. 286, 293. Moreover, a comparison would not help petitioner, *114 particularly in the absence of establishing the extent to which the war effort increased sales.
Actual sales in 1940 were only about $ 12,000 in excess of sales in the last base period year, which indicates that normal was reached in 1939.
Another basis for petitioner's contention that $ 750,000 represents a level of sales during 1939 is alleged ability to acquire customers from competitors; that the larger mills in the area in which it operated were sold for the first time in that year; and that sales to the five largest of them increased 282 per cent in 1941.
Petitioner's application to the Commissioner for relief in 1941 contains statements that in 1939 it obtained some very good accounts from which it had not theretofore received much business and that some of the new customers were listed in Exhibit F of the application. The list contains the names of 15 concerns, 11 of which made purchases of $ 86,870.01 in 1939, and all of them made purchases in 1941 totaling $ 260,375.94. Nixon testified that the list was representative of the larger customers sold for the first time in 1939. Other than proof that two of the customers operated 25 per cent and 50 per cent, respectively, *115 more spindles than Callaway, no showing was made of the productive capacity of the concerns. The record does not establish that the customers selected by petitioner were the larger mills in the area in which it operated. The unreliability of the exhibit is otherwise shown. At least three of the mills made no purchases until 1941, and 1940 was the first year in which another concern made a purchase. One alleged customer made purchases of less than $ 100 in 1939 and 1941, and none in 1940. The purchases of another mill were less than $ 200 in any of the years. Thus, the record before us fails to prove the premise on which the argument of petitioner is made.
*1077 The parties agree that the best index of textile mill requirements for supplies sold by petitioner is reflected in the spindle hours operated in cotton growing states. During the last quarter of 1939 petitioner's net sales were $ 6.39 per thousand spindle hours. Using the same formula, sales were about $ 5.54 in 1940 and $ 8.05 in 1941, a year in which sales to Callaway, a customer which gave petitioner preference in the purchase of its requirements of mill supplies, were about $ 341,000 as compared with about $ *116 177,000 in 1939 and about $ 180,000 in each of the years 1937 and 1938. Sales to Callaway in 1940 are not available. Thereafter sales to 1945, computed on the same basis, did not exceed about $ 7. Petitioner made sales during and after the base period of material to customers outside of the textile industry. No proof was made by petitioner of the extent of such sales and it may not be assumed that they would favor its claim here if we had the figures with which to make the adjustment that would be necessary under a computation by the spindle index.
Petitioner is entitled to excess profits credits of $ 15,321, 2 $ 16,144.58, $ 16,553.19, and $ 16,783.78 for the years 1941, 1942, 1943, and 1944, respectively, under computations based upon the invested capital method. To be entitled to relief under section 722 (b) (4) petitioner is required to establish a level of earnings in 1939 that would result in reconstructive average base period net income which would result in credits in excess of those amounts. Singer Bros., Inc., supra; Blaisdell Pencil Co., 16 T. C. 1469, 1484; Tober-Saifer Shoe Manufacturing Co., 1042">17 T. C. 1042.*117 Petitioner had an earning experience during the base period and "any reconstruction of earnings must bear some relationship to that experience." Avey Drilling Machine Co., supra, p. 1300. The least amount of earnings which petitioner requested us to find for 1939 is eight times actual earnings of $ 4,993.09 for that year. Operating income in 1940 was only $ 10,819.81 and thereafter from a high of about $ 43,000 in 1942 it decreased to about $ 26,000 in 1945. The record made here does not support a finding of assumed earnings in 1939 under the push-back rule sufficient in amount to give petitioner a reconstructive average base period net income which would result in a credit in excess of amounts to which it is entitled without section 722 relief. Accordingly,
Decision will be entered for the respondent.
Reviewed by the Special Division.
Footnotes
1. As appears in joint Exhibits 3-C, except for 1945 which differs slightly from joint Exhibit 2-B.↩
2. Reduced $ 18,724.74 for the sale to Troup County, Georgia.↩
1. Sales to others than Callaway were about $ 16,500 to October 1 and about $ 11,000 during the last quarter.↩
2. Reduced by $ 18,724.74 on account of the sale to Troup County, Georgia.↩
3. As expressed in joint Exhibit 3-C, which differs slightly from joint Exhibit 2-B.↩
1. After giving benefit for unused excess profits credit carry-over from 1940 in the amount of $ 5,714.97.↩
1. Exclusive of $ 5,714.97 as an unused excess profits credit carry-over from 1940 to 1941.↩
1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
(a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. * * *
(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 --
* * * *
(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 * * * furnished, * * *↩
2. Not including $ 5,714.97 as carry-over credit from 1940.↩