*98 Decision will be entered under Rule 50.
Determination made of a fair and just amount representing normal earnings to be used as petitioner's constructive average base period net income for the years 1940, 1941, 1942 and the taxable period January 1 to July 21, 1943.
*1032 The respondent has determined deficiencies in petitioner's income and excess profits taxes as follows:
| Deficiency | ||
| Year | ||
| Income tax | Excess profits | |
| tax | ||
| 1941 | $ 2,691.74 | |
| 1942 | 9,843.56 | |
| Jan. 1 to July 21, 1943 | 3,838.79 | $ 5,106.16 |
In determining the foregoing deficiencies the respondent allowed in part and disallowed in part petitioner's claims for relief under section 722*99 of the Internal Revenue Code of 1939 as follows:
| Claim for relief | |||
| Year | sec. 722 | Allowed | Disallowed |
| 1941 | $ 52,905.39 | $ 8,683.05 | $ 44,222.34 |
| 1942 | 72,292.72 | 15,339.99 | 56,952.73 |
| Jan. 1 to July 21, 1943 | 35,487.36 | 35,487.36 |
*1033 The sole issue presented is the correctness of the respondent's action in determining petitioner's constructive average base period net income.
FINDINGS OF FACT.
Petitioner was organized as a corporation on March 28, 1935, under the laws of the State of California. Its principal place of business was located at Los Angeles. Its tax returns for the periods involved were filed with the collector of internal revenue for the sixth district of California. Petitioner was dissolved on or about July 21, 1943.
At the time of its organization petitioner's capital stock consisted of common stock of $ 15,250, all of which was paid in. There were subsequent changes in capital as follows:
| Amount involved | Net amount of capital at | ||||
| end of year | |||||
| Year | Description | ||||
| Common | 6% preferred | Common | 6% preferred | ||
| stock | stock | stock | stock | ||
| 1935 | No change | $ 15,250 | |||
| 1936 | Cash paid in | $ 3,050 | $ 45,000 | 29,800 | $ 45,000 |
| Transfer from | |||||
| surplus | 11,500 | ||||
| 1937 | Dividend on | ||||
| common | 17,150 | 34,900 | 62,150 | ||
| Cash paid in | 5,100 | ||||
| 1938 | Cash paid in | 1,465 | 36,365 | 62,150 | |
| 1939 | Cash paid in | 1,645 | 5,000 | 38,010 | 67,150 |
| 1940 | Cash paid in | 365 | 38,375 | 67,150 | |
| 1941 | No change | 38,375 | 67,150 | ||
| 1942 | No change | 38,375 | 67,150 | ||
| 1/1/43 to 7/21/43 | Retired | 1 5,015 | 2 67,150 | 33,360 |
Prior to March 28, 1935, William L. Rawn was vice president and sales manager of Hawaiian Cane Products Company of Honolulu with offices in San Francisco, Clyde Johnson was head of the hardware and building materials division of Hammond Lumber Company of Los Angeles, and Henry Moon was Johnson's assistant. The Hammond Lumber Company was one of the oldest and largest lumber dealers on the Pacific Coast and was a distributor for the wallboards, insulation materials, and other products manufactured by Hawaiian Cane Products Company. Financial difficulties had compelled the Hammond Lumber Company to eliminate its hardware and building materials business and Johnson suggested to Rawn that there might be a business opportunity in this situation which should be investigated. Upon investigation Rawn agreed, and the three men, Rawn, Johnson, and Moon, organized the R. J. M. Company. Rawn furnished $ 15,000 of the $ 15,250 invested originally in the petitioner. Rawn had no resources other than the cash so invested. At all times material hereto Rawn was the president and manager of petitioner and owned or controlled not less than*101 55 per cent of petitioner's stock. For about 16 years prior to the organization of petitioner Rawn had been engaged in related businesses. From 1919 to 1927 he was in the foreign and domestic *1034 steel trade in Seattle, operating his own firm from 1923 to 1927. For the next 4 years he was engaged in exporting doors and plywood, and from 1931 until he joined petitioner he was with Hawaiian Cane Products Co. as aforementioned.
By April 1, 1935, Hammond Lumber Company had sold many items out of its hardware and builder's supply inventory. After its organization petitioner purchased a miscellaneous assortment of items from Hammond Lumber Company's remaining inventory. Petitioner purchased no accounts receivable or goodwill, as such, from the Hammond Company. Two former salesmen of the Hammond Company's hardware and builder's supply division were employed by petitioner, and other hardware and builder's supply salesmen were also employed by it during the base period years. Additional items for its hardware and builder's supply business were purchased by petitioner from other concerns.
From April 1, 1935, to May 1940, petitioner engaged in the wholesale hardware and builder's*102 supply business in Los Angeles. Its principal customers were retail hardware dealers, building supply dealers, and country lumberyards in a trading area within 75 to 100 miles of the City Hall in Los Angeles. The merchandise that petitioner offered its customers was the same type of merchandise stocked and offered to the trade by competing wholesale hardware jobbers in the Los Angeles area. It included, among other items, vents, nails, gutters, screen wire, pipe, locks, hinges, cupboard turns, door stops, sash balances, stucco wire, chicken wire, reinforcing mesh, roofing papers, wallboards including plywoods, binder's twine, rope, reinforcing asphalt papers, steel wire, brads, corrugated iron, nuts, bolts, reinforcing steel, black steel sheets, steel fencing, merchant bars, and small channels or angles. Items such as bars, reinforcing bars, galvanized steel sheets, black steel sheets, and merchant bars were handled as an accommodation to customers or in small or negligible amounts during the base period years. Small channels or angles were sold in connection with metal lath and lintels. Petitioner tried to purchase items carried as an accommodation for its customers from the*103 mills, but its purchases were of such small quantities that most of the time the items had to be bought from competing jobbers and petitioner made nothing on the resale thereof to its customers.
From April 1, 1935, until early 1938 petitioner conducted its business in a rented warehouse on East Eighth Street in Los Angeles. This warehouse contained about 11,000 square feet of floor space. In 1937, after surveying various other possible sites, petitioner purchased land from the Union Pacific Railroad Company at Third Street and South Mission Road in Los Angeles. A new warehouse, containing approximately 30,000 square feet of floor space, was completed at this site in 1938. The warehouse was financed for the petitioner *1035 by the Union Pacific. The latter also agreed that petitioner could acquire additional land owned by Union Pacific in the neighborhood as needed. The location of petitioner's new warehouse provided easy access to the trading areas to the north, east, and south by arterial highways.
Petitioner's monthly net sales of hardware and builder's supplies from 1935 through 1939 showed an annual increase as follows:
| Month | 1935 | 1936 | 1937 | 1938 | 1939 |
| January | $ 29,646.38 | $ 45,167.02 | $ 40,963.94 | $ 76,327.12 | |
| February | 27,152.26 | 46,922.13 | 39,365.72 | 85,284.63 | |
| March | 41,099.71 | 65,305.98 | 45,963.70 | 106,919.77 | |
| April | $ 12,882.57 | 37,710.77 | 77,542.53 | 60,136.63 | 92,292.25 |
| May | 22,101.43 | 40,467.06 | 62,995.76 | 60,982.96 | 87,466.05 |
| June | 30,895.33 | 37,732.25 | 62,044.20 | 60,534.77 | 89,059.43 |
| July | 24,047.27 | 39,062.80 | 51,145.28 | 63,403.94 | 91,420.72 |
| August | 37,439.95 | 43,720.38 | 55,206.58 | 76,255.80 | 84,031.89 |
| September | 30,119.56 | 56,798.65 | 65,755.85 | 85,135.69 | 96,652.86 |
| October | 44,001.04 | 51,140.36 | 70,533.05 | 87,638.43 | 101,386.13 |
| November | 32,873.90 | 46,845.31 | 48,606.31 | 73,833.89 | 75,254.74 |
| December | 40,827.51 | 41,642.95 | 37,463.38 | 62,618.32 | 63,751.24 |
| 1 $ 275,188.56 | $ 493,018.88 | $ 688,688.07 | $ 756,833.79 | $ 1,049,846.83 |
During the base period years petitioner captured an increasing percentage of the total wholesale hardware sales in Los Angeles and in the United States.
From 1935 to 1939, inclusive, petitioner's net sales of hardware, cost of sales, gross profit, operating expenses (including other deductions, less other income), and net profit, in dollars and in percentage of net sales, were as follows:
| 1935 (9 months) | 1936 | 1937 | ||||
| Dollars | Per cent | Dollars | Per cent | Dollars | Per cent | |
| Net sales | 267,482.04 | 100.00 | 493,018.88 | 100.00 | 688,688.07 | 100.00 |
| Cost of sales | 230,579.49 | 86.20 | 421,337.87 | 85.46 | 565,100.42 | 82.06 |
| Gross profit | 36,902.55 | 13.80 | 71,681.01 | 14.54 | 123,587.65 | 17.94 |
| Operating exp | 29,463.45 | 11.02 | 54,907.78 | 11.14 | 78,953.86 | 11.46 |
| Excess profits | ||||||
| net income | 7,439.10 | 2.78 | 16,773.23 | 3.40 | 44,633.79 | 6.48 |
| 1938 | 1939 | |||
| Dollars | Per cent | Dollars | Per cent | |
| Net sales | 756,833.79 | 100.00 | 1,049,846.83 | 100.00 |
| Cost of sales | 649,295.43 | 85.79 | 901,670.99 | 85.89 |
| Gross profit | 107,538.36 | 14.21 | 148,175.84 | 14.11 |
| Operating exp | 89,937.54 | 11.88 | 1 117,604.13 | 11.20 |
| Excess profits net income | 17,600.82 | 2.33 | 30,571.71 | 2.91 |
*1036 Petitioner's average base period net income is an inadequate standard of normal earnings because petitioner's business was commenced immediately prior to the base period and its average base period net income does not reflect the normal operation of the business for the entire base period.
From the beginning Rawn was interested in petitioner entering into the wholesale steel business. In 1935 he negotiated unsuccessfully with Union Pacific for the erection of a steel warehouse in the harbor area. In 1936 he discussed petitioner's establishment of a steel department with the California Bank, but was unable to secure an adequate line of credit. In 1936 or early 1937 he discussed credit terms on steel purchases with the Bethlehem Steel Company, and thereafter, from time to time, he discussed petitioner's entry into*106 the steel business with officials of Bethlehem Steel and Union Pacific. Prior to 1939 he made studies of the steel market to determine the type and sizes of steel which petitioner should carry in a steel warehouse and the type of warehouse that should be built. He conferred with various fabricators, sheet metal shops, machine shops, and other potential customers to ascertain their normal day-to-day requirements. During 1939, or prior thereto, he compiled a list of steel items that should be stocked for customers and submitted this list to Bethlehem Steel Company and Columbia Steel Company to check against their sales to other steel distributors. He also considered the rate of turnover that would be necessary to make a wholesale steel warehouse a profitable operation, and determined that four or five turnovers a year would be required.
By December 31, 1938, petitioner's net worth had increased from the original investment of $ 15,250 to $ 115,807.65, so that financially it was able to take definitive steps toward entering the steel business. On August 18, 1939, it commenced negotiations with Bethlehem Steel Company for the purchase of a line of structural steel products. During*107 the same month it commenced discussions with the California Bank for a line of credit to be used largely in connection with the general steel line arranged for with Bethlehem Steel. Officials of the latter visited officials of the California Bank late in August 1939, and assisted petitioner in securing a line of credit from the bank. On September 18, 1939, the California Bank orally advised petitioner that a line of credit had been granted, and confirmed the same by letter dated October 20, 1939. The line of credit amounted to $ 105,000, $ 30,000 of which was to be used in the construction of a new steel warehouse, and $ 75,000 for current operating requirements for its new steel line.
In September 1939, petitioner applied to the Union Pacific Railroad for the purchase of land owned by the latter diagonally across the street from petitioner's hardware warehouse. A contract for the sale *1037 of the property was forwarded by Union Pacific to the petitioner for signature on December 23, 1939. The contract of sale provided for a total purchase price of $ 12,051.72. Petitioner signed the contract and returned it to Union Pacific the following week. Before the end of 1939 petitioner*108 entered into possession of the property and took steps to construct its warehouse thereon. A formal contract, carrying out the agreement of the parties, was executed on January 4, 1940.
On October 11, 1939, petitioner employed Oliver G. Bowen, a building engineer, to draw plans and specifications for the erection of a steel warehouse on the aforementioned property. These plans were completed and filed with the Department of Building and Safety of the City of Los Angeles on December 28, 1939.
On November 22, 1939, petitioner entered into two written contracts with the Cranehoist Conveyor Company of Los Angeles for the construction of three electric overhead traveling cranes in the new warehouse at a total cost of $ 6,400. One of the cranes was of 5-ton capacity and the other two were of 2-ton capacity each.
On December 12, 1939, petitioner entered into a written contract with Pacific Iron and Steel Company of Los Angeles for foundation, paving, structural steel, plumbing, and hardware to be used in the new warehouse.
In May 1940, petitioner completed construction and began operation of its new warehouse for wholesaling steel. The new warehouse contained approximately 30,000 square*109 feet of floor space and had a capacity for warehousing 3,000 to 3,500 tons of steel. Other equipment installed in the steel warehouse included shears, metal saws, sheet slitting and machining, plate burning, and acetylene torch equipment. The steel warehouse was served by an interior railroad track which facilitated the receipt and shipment of steel. There was no such equipment in petitioner's hardware warehouse.
In September or early October 1939 petitioner employed an experienced steel salesman. In November 1939 petitioner employed another experienced steel salesman. During the remainder of 1939 these two salesmen assisted Rawn in compiling inventory lists, examining competitors' operations, compiling customer lists, and contacting prospective customers to inform them of petitioner's plans to open its steel warehouse in the spring of 1940. By the middle of 1940 petitioner had employed five more steel salesmen, all of whom had had experience in selling steel. These salesmen did not call on petitioner's hardware customers except on rare occasions.
The products handled by petitioner in its steel warehouse were primarily items purchased by industrial users who bought for specific*110 and immediate requirements, as contrasted with hardware buyers *1038 who bought a stock of merchandise which was held for sale at retail. The industrial users included sheet metal shops, fabricators, contractors, refineries, shipyards, airplane industries, machinery manufacturers, utilities, transportation companies, and Government agencies. The steel products that petitioner carried for these potential customers included such items as steel rounds, flats, square bars, galvanized sheets, hot-rolled and cold-rolled sheets, plates, angles, channels, I-beams, wide-flanged beams, structural shapes, and strip. Petitioner established a separate department for the sale of items handled in its steel warehouse and maintained a separate sales organization therefor. Steel products were invoiced separately from hardware and builders supply items.
Market conditions during the base period were favorable for petitioner's entry into the steel warehousing business. While there were over 100 steel dealers operating in the Los Angeles and southern California areas during the base period years, there were only about 10 to 20 steel jobbers with whom petitioner would be competing for business. *111 The market for warehousing steel was not crowded and it was stable insofar as price was concerned. The turnover of inventory by iron and steel wholesalers in Los Angeles during 1939 averaged 5.2 times. The competition between steel jobbers for business was good and clean. Petitioner was excellently equipped to enter into and capture a portion of the steel business in the market.
The following table shows monthly net sales, per books, from petitioner's steel warehouse operation (before renegotiation for 1942 and 1943):
| Month | 1940 | 1941 | 1942 | 1943 to |
| July 21 | ||||
| January | $ 26,766.40 | $ 74,155.23 | $ 112,205.08 | |
| February | 40,512.05 | 104,200.40 | 69,651.39 | |
| March | 43,930.91 | 79,333.43 | 86,941.02 | |
| April | 62,705.15 | 64,315.42 | 99,291.36 | |
| May | $ 3,708.39 | 71,266.84 | 62,233.59 | 109,284.11 |
| June | 4,419.07 | 90,719.72 | 58,770.73 | 89,019.01 |
| July | 6,493.02 | 69,719.80 | 61,132.83 | 45,882.48 |
| August | 10,633.65 | 69,425.54 | 61,998.27 | |
| September | 13,870.42 | 60,907.95 | 71,172.37 | |
| October | 21,275.59 | 62,493.93 | 46,252.30 | |
| November | 16,193.58 | 60,859.22 | 58,164.77 | |
| December | 23,949.05 | 78,578.81 | 47,577.20 | |
| Total | $ 100,542.77 | $ 737,886.32 | $ 789,306.54 | $ 612,274.45 |
The following*112 table shows the gross profit, per books, that petitioner earned on its steel warehouse business and, for purposes of comparison, shows the gross profit earned on its hardware business and its total *1039 business (cost of sales as used herein means cost of materials, including freight):
| Year | Total | Hardware | Steel | |
| 1940 | Sales -- net | $ 1,140,433.41 | $ 1,039,890.64 | $ 100,542.77 |
| Cost of sales | 967,006.22 | 892,724.94 | 74,281.28 | |
| Gross profit | $ 173,427.19 | $ 147,165.70 | $ 26,261.49 | |
| 1941 | Sales -- net | $ 1,999,668.98 | $ 1,261,782.66 | $ 737,886.32 |
| Cost of sales | 1,506,534.91 | 1,026,670.04 | 479,864.83 | |
| Gross profit | $ 493,134.07 | $ 235,112.62 | $ 258,021.49 | |
| 1942 | Gross sales | $ 1,686,168.05 | $ 896,861.51 | $ 789,306.54 |
| Cost of sales | 1,288,614.74 | 715,312.81 | 573,301.93 | |
| Gross profit | 1 $ 397,553.31 | $ 181,548.70 | $ 216,004.61 | |
| 1943 (to 7/21) | Gross sales | $ 1,428,419.94 | $ 816,145.49 | $ 612,274.45 |
| Cost of sales | 1,156,593.85 | 670,536.67 | 486,057.18 | |
| Gross profit | 2 $ 271,826.09 | $ 145,608.82 | $ 126,217.27 |
Petitioner's books*113 do not show an allocation of operating expenses or net profit between steel and hardware during the period May 1940 to July 21, 1943. For the latter period petitioner's books show total operating expenses including bonus as follows:
| Year | Total operating expenses |
| 1940 | $ 141,237.26 |
| 1941 | 253,093.34 |
| 1942 | 239,932.91 |
| 1943 to July 21 | 167,374.92 |
During the period 1935 to 1939, inclusive, petitioner's average annual operating expense ratio to hardware sales was 11.34 per cent. If such average operating expense ratio is applied to petitioner's hardware sales for the years subsequent to 1939, namely, the years 1940 through July 21, 1943, a fair allocation of total operating expenses between its hardware and its steel business would result, as follows:
| Operating expenses | ||
| Year | ||
| Hardware | Steel | |
| 1940 | $ 117,923.60 | $ 23,313.66 |
| 1941 | 143,086.15 | 110,007.19 |
| 1942 | 101,704.09 | 138,228.82 |
| 1943 to July 21 | 92,550.90 | 74,824.02 |
The net profits of petitioner's hardware operations and its steel operations, after giving effect to the foregoing allocation of operating expenses for the period 1940 to July 21, 1943, would be as follows: *1040
| Year | Total | Hardware | Steel | |
| 1940 | Gross profit | $ 173,427.19 | $ 147,165.70 | $ 26,261.49 |
| Operating expenses | 141,237.26 | 117,923.60 | 23,313.66 | |
| Net profit | $ 32,189.93 | $ 29,242.10 | $ 2,947.83 | |
| 1941 | Gross profit | $ 493,134.07 | $ 235,112.62 | $ 258,021.45 |
| Operating expenses | 253,093.34 | 143,086.15 | 110,007.19 | |
| Net profit | $ 240,040.73 | $ 92,026.47 | $ 148,014.26 | |
| 1942 | Gross profit | $ 397,553.31 | $ 181,548.70 | $ 216,004.61 |
| Operating expenses | 239,932.91 | 101,704.09 | 138,228.82 | |
| Net profit | 1 $ 157,620.40 | $ 79,844.61 | $ 77,775.79 | |
| 1943 (to 7/21) | Gross profit | $ 271,826.09 | $ 145,608.82 | $ 126,217.27 |
| Operating expenses | 167,374.92 | 92,550.90 | 74,824.02 | |
| Net profit | 1 $ 104,451.17 | $ 53,057.92 | $ 51,393.25 |
For the period 1935 to July 21, 1943, petitioner's operations, expressed in percentages of gross and net profits to sales, showed the following results:
| Total | Hardware | Steel | ||||
| Year | Gross | Net | Gross | Net | Gross | Net |
| Per cent | ||||||
| 1935 | 13.80 | 2.78 | 13.80 | 2.78 | ||
| 1936 | 14.54 | 3.40 | 14.54 | 3.40 | ||
| 1937 | 17.94 | 6.48 | 17.94 | 6.48 | ||
| 1938 | 14.21 | 2.33 | 14.21 | 2.33 | ||
| 1939 | 14.11 | 2.91 | 14.11 | 2.91 | ||
| 1940 | 15.21 | 2.82 | 14.25 | 2.81 | 26.10 | 2.93 |
| 1941 | 24.66 | 12.00 | 18.64 | 7.29 | 34.97 | 20.05 |
| 1942 | 1 21.95 | 1 7.43 | 20.24 | 8.90 | 27.37 | 9.86 |
| 1943 to July 21 | 1 18.20 | 1 6.36 | 17.84 | 6.50 | 20.61 | 8.39 |
From 1941 to July 21, 1943, governmental restrictions and increased freight rates handicapped petitioner in its steel operations, curtailing the amount of steel it could handle and reducing the profits on such steel as it could acquire. In June 1941 the Government began allocating steel with preference given to defense requirements. In August*115 1941 the Government established preferential ratings and required steel orders to be filled in accordance therewith. In September 1941 the Government fixed a quota for each steel warehouse based on shipments during the first quarter of 1941 and prohibited acceptance of steel in excess of such quota. This order curtailed the petitioner's steel sales to a greater extent than the preceding orders because the first quarter of 1941 occured prior to completion of its first full year of operation. The restrictions curtailed the steel warehousing business generally, the amount of steel handled dropping from an average 14.36 per cent of steel produced for sale in the base period years, and from 15.09 per cent in 1941, to 9.84 per cent for 1942, and 10.95 per cent in 1943.
*1041 During 1940 and 1941 the Bethlehem Steel Company was petitioner's principal source of supply for steel. Bethlehem shipped its steel from its eastern mills to the west coast by intercoastal steamers. Its steel prices on the west coast included the ocean freight costs. Petitioner's steel warehouse was located in a free switching area which eliminated freight costs on such incoming steel. As Bethlehem became*116 more involved in the production of materials for defense and war, its supply of steel available to petitioner dwindled. During this same time the intercoastal steamers were gradually being converted to other uses so that petitioner not only had to seek other sources of supply but also had to use the more expensive all-rail shipment of steel. On steel shipments from the east, petitioner absorbed the difference between the all-rail and the ocean freight rates. The increase in petitioner's freight costs is shown in the following table:
| Year | Steel sales | Freight-in on | Ratio of freight |
| steel | costs of sales | ||
| Per cent | |||
| 1940 | $ 100,542.77 | ||
| 1941 | 737,886.32 | $ 26,126.54 | 3.54 |
| 1942 | 789,306.54 | 60,565.48 | 7.67 |
| 1943 to July 21 | 612,274.45 | 77,266.06 | 12.62 |
Petitioner's average base period net income is an inadequate standard of normal earnings because during a taxable year subsequent to the base period there was a change in the capacity for production or operation of its business as a result of a course of action to which petitioner was committed prior to January 1, 1940. The business of the petitioner did not reach, by the end of the base period, the earning level*117 which it would have reached if it had completed and begun operating its warehouse for wholesaling steel 2 years before the end of the base period. The petitioner's excess profits tax computed under the Internal Revenue Code without the benefit of section 722 results in an excessive and discriminatory tax.
On February 11, 1938, petitioner and William L. Rawn entered into a written contract whereby Rawn was employed as general manager and was to be paid a monthly salary of not less than $ 600 and a percentage of the net profits. Under the formula provided by the agreement, petitioner had to have net profits in excess of certain prescribed requirements, designated "minimum net profits," before Rawn was entitled to any portion of petitioner's net profits. On amounts in excess of petitioner's "minimum net profits" Rawn was to receive 5 per cent of the first $ 5,000, and 1 per cent more on each additional $ 1,000 thereafter, but not more than 30 per cent of the net profits of any 1 year. Rawn received nothing under this contract for 1938, but received the following amounts as a bonus under the contract for the years 1939 to 1943, inclusive: *1042
| Year | Amount |
| 1939 | $ 3,042.37 |
| 1940 | 2,375.39 |
| 1941 | 32,327.76 |
| 1942 | 11,633.60 |
| 1943 to July 21 | 401.15 |
*118 The business formerly conducted by petitioner has been conducted by a partnership since July 22, 1943. This partnership began with the same owners and the same capital as petitioner, and has continued to operate at the same location under the same name as petitioner.
Petitioner filed timely excess profits tax returns and timely applications for relief under section 722, Internal Revenue Code of 1939, for the taxable years involved herein. No excess profits tax was due or paid by petitioner for the year 1940. For the taxable years 1941, 1942, and the period January 1 to July 21, 1943, the petitioner paid excess profits taxes and interest on the dates and in the amounts set forth in paragraphs 18, 19, and 20 of the stipulation of facts which paragraphs are incorporated herein by reference.
Petitioner's excess profits credit for the year 1940 computed (under the average earnings method) without the benefit of section 722, according to the law applicable to 1941, and petitioner's excess profits credits for the years 1941 and 1942 and the period January 1 to July 21, 1943, computed (under the average earnings method) without the benefit of section 722, are as follows:
| Average base | Credit 95 per | |
| Taxable year | period net | cent of |
| income | ABPNI | |
| 1940 (1941 law) | $ 27,394.89 | $ 26,025.15 |
| 1941 | 27,394.89 | 26,025.15 |
| 1942 | 29,001.98 | 27,551.88 |
| 1943 to July 21 | 29,001.98 | 27,551.88 |
*119 Petitioner's excess profits net income for 1940, computed according to the law applicable to 1941, is $ 32,189.93. Its excess profits net income for each of the years 1941 and 1942, and the period January 1 to July 21, 1943, is $ 240,040.73, $ 122,620.40, and $ 90,009.17, respectively.
Respondent determined that petitioner was entitled to relief under section 722 of the Internal Revenue Code of 1939 and allowed petitioner's applications for relief in part and disallowed them in part. The constructive average base period net income determined by respondent for the calendar years 1940, 1941, 1942, and the period January 1 to July 21, 1943, was $ 32,630, $ 45,675, $ 48,937, and $ 48,937, respectively. In determining the constructive average base period net income for steel, respondent used constructive sales of steel for 1939 of $ 250,000, an index of 102.4, and a constructive average net profit percentage of 6.37 to arrive at an amount of $ 16,307. In determining *1043 the constructive average base period net income for hardware, respondent used actual 1939 sales of hardware in the amount of $ 1,049,847 and reconstructed net income for the base period years as follows:
| Gross | Operating | Reconstructed | |||||
| Year | Index | Reconstructed | profit | Gross | expense | Operating | net income |
| sales | margin | profit | ratio | expense | (before | ||
| additional | |||||||
| bonus) | |||||||
| Per cent | Per cent | ||||||
| 1936 | 129 | $ 825,794 | 14.54 | $ 120,070 | 11.14 | $ 91,993 | $ 28,077 |
| 1937 | 148 | 947,423 | 17.95 | 170,062 | 11.35 | 107,533 | 62,530 |
| 1938 | 105 | 672,158 | 14.21 | 95,514 | 11.94 | 80,256 | 15,258 |
| 1939 | 164 | 1,049,847 | 14.11 | 148,176 | 11.25 | 118,138 | 30,038 |
| Total | $ 135,903 | ||||||
| CABPNI for hardware (before additional bonus) | 33,980 | ||||||
| Less: Additional bonus | 1,350 | ||||||
| CABPNI for hardware | $ 32,630 |
*120 Application of the variable credit rule to 1940 resulted in no CABPNI for steel for that year and 80 per cent of the CABPNI determined for steel was used in determining the total CABPNI for 1941. The index used by respondent in reconstructing sales of hardware for the base period years is the total wholesale sales of lumber and construction materials in the United States with 1935 sales equalling 100. The gross profit margins and operating expense ratios used in reconstructing sales of hardware for the base period years represent petitioner's own experience in such years.
In reconstructing petitioner's sales of hardware for the base period years, respondent used index figures based upon wholesale sales of lumber and construction materials in the United States for 1935, as reported in the "Census of Business: 1935," an estimate for 1936, figures computed upon the basis of sample figures reported for the years 1937 and 1938 in the "Census Survey of Business: 1937-38," and actual totals as reported in the "Census of Business: 1939" for 1939.
The United States Department of Commerce revised its wholesale sales in the United States in the Survey of Current Business for August 1948. *121 The revised figures for the wholesale sales of lumber and construction materials in the United States during the base period years are reflected in the following table, together with index figures for such years:
| Sales in millions | ||
| Year | of dollars | Index 1939=100 |
| 1936 | 1132 | 90 |
| 1937 | 1310 | 104 |
| 1938 | 1072 | 85 |
| 1939 | 1264 | 100 |
*1044 The Survey of Current Business for August 1948 shows revised figures for wholesale sales of hardware in the United States for the base period years. Such sales are reflected in the following table together with index figures for the base period years:
| Sales in millions | ||
| Year | of dollars | Index 1939=100 |
| 1936 | 529 | 89 |
| 1937 | 600 | 101 |
| 1938 | 528 | 89 |
| 1939 | 592 | 100 |
The index figures for wholesale sales of hardware for the United States during the base period years more nearly approximate petitioner's experience and business conditions during such base period years than the wholesale sales index figures used by respondent, or such index figures for the lumber and construction materials business, as revised, using 1939 wholesale sales as equalling 100.
Total dollar sales of steel by seven warehouses in Los Angeles for the years 1936*122 to 1939, inclusive, as computed by respondent from tax returns, show the following pattern:
| Dollar sales of steel by | |
| seven warehouses in L.A. | |
| Year | 1939=100 |
| 1936 | 96.81 |
| 1937 | 120.02 |
| 1938 | 92.63 |
| 1939 | 100.00 |
| Average 1936-39 | 102.4 |
The index figure of 102.4 was the index used by respondent in reconstructing petitioner's average base period net income for steel as hereinbefore mentioned.
Total sales of steel by all United States warehouses, whether on a dollar or tonnage basis, show a different pattern for the country as a whole from the Los Angeles area. Index figures on both bases show the following pattern:
| Dollar sales of | Tonnage sales | |
| Year | steel 1 | of steel |
| 1939=100 | 1939=100 | |
| 1936 | 81.5 | 88.8 |
| 1937 | 103.2 | 93.9 |
| 1938 | 73.7 | 69.3 |
| 1939 | 100.0 | 100.0 |
| Average 1936-39 | 89.6 | 88.0 |
If petitioner's steel warehouse had been built and placed in operation on January 1, 1938, its 1939 sales of steel under the operating conditions confronting petitioner and other steel jobbers in 1938 and *1045 1939 would have been $ 600,000. *123 Such steel would have been sold at the same competitive prices received by other steel jobbers, and petitioner would have derived an average gross profit therefrom of at least 28 per cent. Petitioner's ratio of operating expenses on such sales would have exceeded its ratio of operating expenses to sales of hardware. Petitioner's average net profit on such sales would have been at least 12 per cent.
The stipulated facts are so found and are incorporated herein by reference. Petitioner's profit and loss statement (Exhibit 14 attached to the stipulation of facts) for the years April 1, 1935, through July 21, 1943 (after renegotiations), with ratios to net sales, is found as a fact and incorporated herein by reference.
Petitioner's constructive average base period net income is $ 36,296 for 1940, $ 95,278 for 1941, $ 110,024 for 1942, and $ 110,024 for the taxable period January 1, 1943, to July 21, 1943.
OPINION.
The only issue involved here concerns the reconstruction of petitioner's average base period net income. Respondent admits that, as to petitioner's hardware business which was commenced in 1935, the average base period net income is an inadequate standard of normal earnings*124 because the business was commenced immediately prior to the base period within the meaning of section 722 (b) (4) of the 1939 Code. With respect to petitioner's wholesale steel warehouse which began operation in May 1940, respondent also concedes that petitioner's average base period net income is an inadequate standard of normal earnings because there was a change in the capacity for production or operation of its business as a result of a course of action to which petitioner was committed prior to January 1, 1940. Respondent further admits that petitioner's steel business did not reach by the end of the base period the earning level which it would have reached if it had begun operating its warehouse for wholesaling steel 2 years before the end of the base period. It is conceded by respondent, therefore, that because of the commencement of the hardware business immediately prior to the base period and the change in the capacity for production or operation of the business as a result of a course of action to which petitioner was committed prior to January 1, 1940, petitioner's excess profits tax computed without the benefit of section 722 results in an excessive and discriminatory*125 tax, entitling petitioner to relief under section 722 (b) (4).
Respondent has allowed a constructive average base period net income for 1940 of $ 32,630, for 1941 of $ 45,675, for 1942 of $ 48,937, and for the taxable period January 1, 1943, to July 21, 1943, of $ 48,937. Petitioner contends that instead of these amounts it is entitled *1046 to a constructive average base period net income for 1940 of $ 36,300, for 1941 of $ 110,028, for 1942 of $ 128,460, and for the taxable period January 1, 1943, to July 21, 1943, of $ 128,460.
The parties are in agreement as to the method to be employed in arriving at a constructive average base period net income to be used in lieu of petitioner's admittedly inadequate actual average base period net income and they are also in agreement as to all but three of the factors to be used in applying that method. The three factors in issue are: (1) The constructive annual sales level of steel which petitioner would have attained by the end of the base period if its steel warehouse had begun operations on January 1, 1938; (2) the average net profit margin which petitioner would have received on such sales during the base period; and (3) the appropriate*126 index to be used for back-casting petitioner's 1939 hardware sales to the prior base period years.
Respondent contends that if petitioner had commenced operation of its steel warehouse on January 1, 1938, its sales level for steel products would have reached $ 250,000 by the end of 1939. Petitioner maintains that if its warehouse had been placed in operation on January 1, 1938, its 1939 sales of steel would have reached $ 600,000. In support of its position, petitioner relies on the testimony of William L. Rawn, C. P. Desmond, and William H. Budd.
Rawn, petitioner's president, based his estimate of $ 600,000 for 1939 sales on a study of the market he had made during the base period.
Desmond, formerly assistant treasurer of Bethlehem Steel in charge of treasury functions for the southern California district, had visited petitioner's steel warehouse frequently and was familiar with its size, arrangement, equipment, accessibility to customers, and sales organization. Inasmuch as he was thoroughly familiar with steel warehouse operations in Los Angeles during the base period, since practically all such warehouses were customers of Bethlehem Steel, and in view of the fact that he had*127 been associated with Bethlehem for 43 years, Desmond was particularly well qualified to give an opinion concerning petitioner's reconstructed base period steel sales. Desmond estimated that petitioner could have expected to achieve an annual sales level of $ 600,000 to $ 750,000 per year by the end of 1939 if it had begun operation of its steel warehouse on January 1, 1938. This estimate was based upon his opinion that under base period conditions petitioner would have handled 30 to 40 carloads of steel per month, at an average cost of $ 1,200 to $ 1,500 per car (based on 20-ton cars and $ 60 to $ 70 per ton average mill price) and at an average gross profit of 35 per cent. Using Desmond's minimum figures, 30 cars at $ 1,200 per car, and adding 35 per cent of sales price as gross profit, petitioner's 1939 sales figures would have approximated $ 55,385 per month or $ 664,620 annually.
*1047 Budd, petitioner's sales manager who previously was a steel salesman with another Los Angeles concern, stated that, in his opinion, petitioner would have achieved an annual sales level of $ 700,000 to $ 720,000 for steel products by the end of 1939 if the warehouse had been completed and*128 its operation commenced on January 1, 1938. Budd testified that his estimate was based primarily on his experience with another Los Angeles steel company, the only new company to enter the steel warehouse business in that area during the base period.
The average annual turnover of inventory by iron and steel wholesalers in Los Angeles in 1939 was slightly over five times. In 1939, petitioner committed itself to erect a warehouse having a capacity for warehousing 3,000 to 3,500 tons of steel, anticipating an inventory turnover of four or five times per year. At the prevailing selling price of $ 100 per ton, a turnover of 2,000 tons only three times a year would amount to $ 600,000.
In view of the foregoing evidence, we do not believe that respondent was justified in using an inventory as low as 1,000 to 1,500 tons, an annual turnover of only 2 1/2 or 3 times, and a sales price of only $ 46 per ton upon which to base his reconstruction of 1939 sales.
We are satisfied that the record justifies our finding that if petitioner's steel warehouse had been placed in operation on January 1, 1938, its 1939 sales of steel would have reached $ 600,000.
With respect to the average net profit*129 margin which petitioner would have received on steel sales by the end of 1939, the record shows that the price structure for steel in Los Angeles during the base period was very stable and petitioner's policy was to keep its prices in line with those of its competitors. Competing warehouses fixed their prices so as to provide a gross profit margin of not less than 28 to 30 per cent. Petitioner was served by the same suppliers as the other warehouses and could therefore purchase steel at the same price. Further, it was located in a "free" rail-switching area where, during the base period years, it would incur no incoming freight costs. Under the above circumstances we think petitioner would have derived an average gross profit of at least 28 per cent. Throughout the period 1935 to 1939, petitioner maintained its ratio of operating expense to hardware sales at an average of 11.34 per cent. Petitioner's president, Rawn, testified that he anticipated that the expense of the steel warehouse would not vary from the hardware warehouse expense by more than 2 to 2 1/2 per cent. While the evidence indicates that the ratio of petitioner's operating expenses on steel sales would have exceeded*130 substantially its ratio of operating expenses on hardware sales, we are of the opinion that the record as a whole warrants the conclusion that its average net profit on such sales would have reached 12 per cent during 1939.
*1048 Although we do not approve respondent's method of computing petitioner's base period net profit margin, if the figures utilized therein had correctly reflected petitioner's renegotiation refund in 1942 and 1943 and the increased freight costs incurred in those years due to the curtailment of ocean shipping, which years have significance here only because of the variable credit rule, the respondent's method of computation would have yielded a base period net profit on steel of approximately 12 per cent, as compared with the 6.37 per cent margin allowed by him.
The appropriate index figures to be utilized in back-casting petitioner's hardware sales over the base period years would seem clearly to be the wholesale hardware sales index figures, as they more nearly approximate petitioner's experience during the base period than the indexes for the lumber and construction materials business used by respondent.
By utilizing a $ 600,000 level for steel sales*131 for 1939, a net profit margin of 12 per cent on such sales, and the wholesale hardware indexes for reconstructing petitioner's base period hardware sales, under the method of reconstruction agreed upon by the parties, we have determined petitioner's constructive average base period net income to be $ 36,296 for 1940, $ 95,278 for 1941, $ 110,024 for 1942, and $ 110,024 for the taxable period January 1, 1943, to July 21, 1943.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. Retired July 20, 1943.↩
2. Retired June 29, 1943.↩
1. Annex 8 attached to the stipulation of facts shows a total of $ 267,482.04. The discrepancy is unexplained. Paragraph 9 of the stipulation of facts states that "Annex 8 reflects petitioner's total net sales, cost of sales, operating expenses and net profit after renegotiations but before Federal income and excess profits taxes for the years 1935 through 1942 and the period from January 1 to July 21, 1943, as finally determined by respondent." The discrepancy may, therefore, result from adjustments made by respondent.↩
1. Includes bonus.↩
1. Does not reflect adjustment for renegotiation refund of $ 35,000.↩
2. Does not reflect adjustment for renegotiation refund of $ 14,442.↩
1. Before renegotiation, i. e., $ 35,000 for 1942, and $ 14,442 for 1943.↩
1. After renegotiation. The percentages of profit to sales before renegotiation would be 23.58 gross and 9.35 net for 1942, and 19.03 gross and 7.31 net for 1943.↩
1. Based on composite price per ton for finished steel times total tonnage of steel sold by all U. S. warehouses.↩