*28 Decisions will be entered under Rule 50.
The petitioner claims relief from excess profits tax under the provisions of Code sections 722 (a) and 722 (b) (3) (A). Held, petitioner has established the qualifying factors requisite to such relief and has established the amount that would be fair and just as the average of normal income for the base period years.
*252 Waldorf System, Inc., is the parent corporation of an affiliated group and will herein be referred to as the petitioner.
The respondent determined deficiencies and overassessments in the income and excess profits tax liabilities of the petitioner and its affiliated*29 corporations for the calendar years and in the amounts as follows:
| Income tax | |||
| Excess profits | |||
| Year | tax deficiency | ||
| Deficiency | Overassessment | ||
| 1941 | $ 1,755.29 | $ 4,759.47 | |
| 1942 | 14,407.27 | 10,969.20 | |
| 1943 | 13,914.51 | 102,842.86 | |
| 1944 | 14,313.04 | 27,540.67 | |
| 1945 | $ 1,819.53 | 5,106.54 | |
| Total | $ 1,819.53 | $ 44,390.11 | $ 151,218.74 |
In connection with the foregoing determinations, the respondent rejected claims for relief from excess profits tax liability filed by the petitioner under Code section 722 and gave formal notice of such disallowance.
As to the deficiencies, the petitioner alleges error in the determination on the ground that the amounts set forth were paid to the collector before the issuance of the notice. Facts have been stipulated which establish the dates and amounts of assessments and payments made. If any decision need be made on this issue, it can be made under Rule 50 on the basis of the stipulated figures.
The petitions allege error in the respondent's failure to allow relief under the provisions of Code section 722, subsection (b) (3) (A) on the ground of the existence of a variant profits cycle, and subsection (b) (4) on*30 the ground of a change in the character of the petitioner's business. The parties have stipulated that the petitioner has established *253 its right to reconstruct normal earnings under section 722 (b) (4) and that the result thereof is that the petitioner is entitled to additional constructive average base period net income in the amount of $ 75,000. This allowance affords no relief to the petitioner as the excess profits credit based on such increased income is less than the credit computed on invested capital.
The applications for relief and claims filed are for the refund of excess profits taxes for years and amounts as follows:
| Year | Amount |
| 1941 | $ 89,703.96 |
| 1942 | 142,541.41 |
| 1943 | 880,995.74 |
| 1944 | 241,874.90 |
| 1945 | 5,106.54 |
| Total | $ 1,360,222.55 |
In addition to the claims for relief for the taxable years based on constructive average base period net income for those years, the petitioner alleges that it is entitled also to reconstruct for the year 1940 which would give it an unused excess profits credit carry-over from 1940 to 1941.
Summarizing the above, the issue to be decided is whether or not the petitioner is entitled to relief from excess profits taxes*31 under the provisions of Code section 722, subsections (a) and (b) (3) (A). No claim for relief is made on behalf of the petitioner's subsidiaries.
The proceeding was heard before Raymond J. Bowen as a Commissioner designated for that purpose pursuant to Rule 48 of the Rules of Practice before The Tax Court and section 1114 (b) of the Internal Revenue Code. Objections filed by the parties to the report of the Commissioner have been carefully considered. The findings of fact herein are substantially as found by the report of the Commissioner.
FINDINGS OF FACT.
I. General Facts.
For all years pertinent hereto, the petitioner and its affiliated corporations maintained their books and records in accordance with the accrual method of accounting, and for the excess profits tax years involved in these proceedings they filed consolidated Federal excess profits tax returns on a calendar year basis in accordance with that method of accounting. The consolidated returns were filed in the name of Waldorf System, Incorporated, as the common parent.
The excess profits net income (or loss) of each of the affiliated corporations, and of the consolidated group, for the base period years 1936*32 to 1939 was as follows: *254
| Year | Waldorf | Clark | Ginter |
| 1936 | $ 513,901.96 | $ 174,090.78 | $ 2,044.31 |
| 1937 | 302,339.39 | 167,698.90 | (18,914.82) |
| 1938 | 118,104.98 | 60,877.87 | (8,513.83) |
| 1939 | 266,759.73 | 129,599.61 | (22,321.77) |
| $ 1,201,106.06 | $ 532,267.16 | $ (47,706.11) | |
| General | |||
| average | 300,276.51 | 133,066.79 | $ (11,926.52) |
| Year | St. Clairs' | Fort Hill | Consolidated |
| 1936 | $ (3,684.74) | $ 666.43 | $ 687,018.74 |
| 1937 | 3,382.93 | 738.07 | 455,244.47 |
| 1938 | 8,449.12 | 623.87 | 179,542.01 |
| 1939 | 5,090.18 | 526.77 | 379,654.52 |
| $ 13,237.49 | $ 2,555.14 | $ 1,701,459.74 | |
| General | |||
| average | $ 3,309.37 | $ 638.79 | $ 425,364.93 |
As computed under the provisions of section 713 (e) of the Internal Revenue Code, the average base period net income of the consolidated group was $ 475,599.30.
The excess profits tax credits of the consolidated group for the taxable years, computed under the invested capital method provided by Internal Revenue Code section 714, were as follows:
| Invested | |
| Year | capital credit |
| 1941 | $ 520,778.44 |
| 1942 | 515,515.46 |
| 1943 | 510,478.36 |
| 1944 | 498,179.15 |
| 1945 | 489,945.75 |
The amounts of excess profits net income of the*33 several corporations and consolidated excess profits net income, computed under the invested capital method, for the years 1940 to 1945 were as follows:
| Waldorf | Clark | St.Clair | |
| Year | Division | Division | Division |
| 1940 | $ 382,683.62 | $ 101,997.62 | $ 12,581.82 |
| 1941 | 584,894.66 | 128,364.50 | 18,259.13 |
| 1942 | 462,352.20 | 217,852.86 | 42,475.86 |
| 1943 | 1,040,489.10 | 441,387.07 | 91,546.84 |
| 1944 | 166,001.22 | 504,352.26 | 96,290.30 |
| 1945 | (558.33) | 363,219.40 | 99,965.88 |
| Ginter | Ft. Hill | Total | |
| Year | Division | Division | Consolidated |
| 1940 | $ (23,616.62) | $ 552.75 | $ 474,199.19 |
| 1941 | (394.68) | 591.69 | 731,715.30 |
| 1942 | 13,824.62 | 585.50 | 737,091.04 |
| 1943 | 34,434.30 | 395.90 | 1,608,253.21 |
| 1944 | 28,354.28 | 687.21 | 795,685.27 |
| 1945 | 44,025.04 | 908.29 | 507,560.28 |
The amounts of excess profits net income shown above for the year 1940 are after deduction of Federal income taxes. Prior to such deduction, the amounts of such income would be as follows:
| Waldorf | $ 443,830.10 |
| Clark | 134,207.39 |
| St. Clairs' | 14,969.25 |
| Ginter | (23,616.62) |
| Ft. Hill | 649.15 |
| Consolidated | 570,039.27 |
The petitioner, Waldorf System, Inc., is a corporation organized on April 18, 1919, under*34 the laws of Massachusetts, with its principal office and place of business at 169 High Street, Boston, Massachusetts.
The consolidated excess profits tax returns for the taxable years were filed with the collector of internal revenue for the district of Massachusetts. The returns were filed by the petitioner on behalf of *255 itself and for its wholly owned subsidiaries, namely, The Clark Restaurant Company, the Ginter Restaurant Company, St. Clairs', Inc., and the Fort Hill Supply Company.
The petitioner is both a holding corporation and an operating corporation. From the time of its incorporation through the taxable years, it operated a chain of cafeterias (hereinafter referred to as the Waldorf Division), in addition to owning the entire stock of its four affiliated corporations from the dates of acquisition thereof as shown below.
II. Facts as to Affiliated Corporations.
The Clark Restaurant Company was incorporated under the laws of Ohio in 1919. Its entire capital stock was acquired by the petitioner on or about January 1, 1922. The restaurants 1 operated by it (hereinafter referred to as the Clark Division) are operated under the name of "Clark's" and consist *35 of combination counter and waitress-table service. All of the restaurants of Clark Division were located in Ohio with the exception of one located at Erie, Pennsylvania.
The Ginter Restaurant Company was incorporated under the laws of Massachusetts in January 1927, and at that time its entire capital stock was acquired by the petitioner. The restaurants operated by it (hereinafter referred to as Ginter Division), were of the waitress-table type except one which had only counter service with some incidental over-the-counter bakery sales. All of the restaurants operated by Ginter Division were located in Boston, Massachusetts.
St. Clairs', Inc., was incorporated in 1907 under the laws of Massachusetts, and its entire capital stock was acquired by the petitioner on or about July 1, 1929. The restaurants*36 operated by it (hereinafter referred to as the St. Clair Division) were of the table and counter type served by waitresses. All of the restaurants operated by the St. Clair Division were located in Massachusetts.
Fort Hill Supply Company (hereinafter referred to as Fort Hill) is a Massachusetts corporation organized on March 7, 1927, by the petitioner which then acquired all of its capital stock. It was organized for the purpose of operating as a wholesale jobber of restaurant equipment. Its principal customers are the above mentioned Waldorf, Clark, Ginter, and St. Clair Divisions of the petitioner.
III. Extent and Method of Operations of Waldorf Division.
General Facts.
During the period covered by the years 1922 to 1939, Waldorf Division operated cafeterias in the States of New York, Massachusetts, *256 Connecticut, and Rhode Island. The number of restaurants operated by it and its affiliated operating corporations at the close of each year was as follows:
| Waldorf | St. | ||||
| Year | Division | Clark | Ginter | Clairs' | Total |
| 1922 | 93 | 10 | 103 | ||
| 1923 | 100 | 13 | 113 | ||
| 1924 | 106 | 15 | 121 | ||
| 1925 | 104 | 16 | 120 | ||
| 1926 | 110 | 17 | 127 | ||
| 1927 | 112 | 18 | 8 | 138 | |
| 1928 | 111 | 25 | 8 | 144 | |
| 1929 | 114 | 25 | 7 | 10 | 156 |
| 1930 | 118 | 26 | 7 | 11 | 162 |
| 1931 | 124 | 27 | 6 | 10 | 167 |
| 1932 | 124 | 31 | 6 | 10 | 171 |
| 1933 | 119 | 29 | 6 | 7 | 161 |
| 1934 | 117 | 28 | 4 | 6 | 155 |
| 1935 | 112 | 26 | 4 | 6 | 148 |
| 1936 | 115 | 23 | 3 | 5 | 146 |
| 1937 | 118 | 21 | 3 | 4 | 146 |
| 1938 | 116 | 18 | 2 | 4 | 140 |
| 1939 | 115 | 19 | 1 | 4 | 139 |
*37 The restaurants operated by Waldorf Division were of the cafeteria type. They differed from the usual cafeteria in that there was no rail in front of the counter and steam table from which food was served. Customers could approach directly that part of the service counter which contained the articles of food they desired and did not need to get in a line. Upon being served at the counter, the customers carried the food to tables where it was consumed.
Restaurants and cafeterias that are members of chains customarily carry some sign that identifies them as being a part of a particular chain. In the case of Waldorf Division, the identifying sign was a big red apple bearing the name "Waldorf." Food prices in chain restaurants are generally low in relation to prices in other types of restaurants.
The pattern of operations of Waldorf Division was generally the same in the base period and for many years prior thereto. All operations were directed from the petitioner's headquarters at 169 High Street, Boston, Massachusetts. At those headquarters, control was maintained over purchases of provisions and equipment, personnel, medical services, and leasing and real estate operations. *38 Accounting and financial operations were centered in the Boston headquarters. The claims department was located there. The Boston headquarters made up all menus, weekly, for all of the Waldorf Division cafeterias. It made up recipes and tested them before sending them out to the operating divisions. There were maintained and operated at headquarters a laundry and central commissary and bakery. A great deal of the jams, jellies, and tomato juice used by the cafeterias was prepared at the headquarters commissary. Each major operation at headquarters was under the direction of a manager who was a well-paid expert.
*257 The petitioner's management in the Boston headquarters maintained close control and supervision of the purchases of provisions. As to large quantity purchases, decisions were made as the result of joint consideration by the petitioner's president, general manager, and the head of the purchasing department. The cost of provisions was of critical importance in the petitioner's business and commodity prices were watched closely. In making purchases, management first determined the quantity of a given commodity that would be required by its restaurants over a *39 period of months. It attempted to determine the future market prospects of that commodity. If it appeared that there was a possibility of a rise in price, purchases were made of a sufficient quantity to last for a period of at least 9 months. Constant checking of markets often disclosed weak spots due to an over-supply in the hands of a producer or distributor. This situation would enable the petitioner to buy at a price below the market, and in such cases it would purchase large quantities. Commodity prices in different cities were watched, and advantage was taken of any differential in prices by purchasing in the lower priced market. If prices were lower in New York than in Boston, the petitioner's management would buy in New York and ship the merchandise to Boston in large vans that were rented on a favorable round-trip rental basis.
It was the practice of the petitioner's management to purchase a large part of its provisions directly from producers. By so doing it eliminated the jobber and his profit. If the producers offered a commodity at a favorable price, the petitioner would purchase a large quantity. It would sometimes buy as much as 10 carloads of turkeys. At one*40 time, on a favorable price offer, it purchased 14 carloads of pork loins. Seafood was purchased at the docks. One factor that enabled the petitioner to obtain the advantage of low prices was that it carried a sufficiently large cash balance so that it was able to, and did, pay cash on the delivery of supplies.
Waldorf Division management set up detailed, written standards or specifications covering practically every item of food purchased. For example, it was specified that pork loins must be not lighter than 8 pounds nor heavier than 12, and that turkeys must weigh between 22 and 24 pounds. The written specifications were sent to suppliers who were required to meet them on all commodities that they sold to Waldorf Division.
Menus were made up each week in conferences among the president, the treasurer, and heads of the purchasing and commissary departments. The petitioner had cost figures on all of its provisions, and the menus were prepared with a view to selling the provisions on hand that had been purchased at comparatively low prices, or such provisions as were then on the market at low prices. The menus usually carried 10 or 12 standard items in addition to pastries. *41 The menus *258 were posted in the cafeterias and customers were supplied only with the items so shown, except that short orders would be filled.
If a new recipe proved satisfactory after testing at Boston headquarters, the recipe was sent out to the division commissaries for use in the preparation of food for the individual cafeterias.
The management in Boston maintained a strict policy with respect to quantity and portions of food served in the cafeterias. When weekly menus were sent out, the size of the individual order was specified as to every item. The quantity of the ingredients that went into pastries was specified by headquarters so that the finished product was uniform in all cafeterias.
During the period 1922 to 1939, Waldorf Division's operations were grouped into four geographical divisions, each of which was headed by a superintendent. The superintendent reported directly to the assistant to the president. Next in the chain of command were supervisors, each of whom usually was in charge of a city. Under the supervisors there came the store, or cafeteria, managers within the city. Each store manager was in charge of an operating unit, or cafeteria.
Each division*42 superintendent had at least one commissary under his supervision. Each local commissary had a manager in charge who took instructions from the division superintendent. Boston headquarters shipped raw material to the local commissaries which prepared the food that was served to the patrons of the cafeterias. The local commissaries made pies, cakes, and pastries in large quantities. They prepared the cooked foods that were listed on the daily menus that were sent out from Boston headquarters. They also prepared food for short-order cooking in the individual cafeterias. The food so prepared in the commissaries was packed in large vacuum cans and delivered daily to the individual cafeterias that were within the geographical division. The cafeterias, on receipt of the large vacuum containers, removed portions and placed them in smaller containers on the steam table. Only enough food was placed in the steam containers to meet what was judged to be the current need. If an unusual run developed for a particular item, the manager of the cafeteria telephoned his supplying commissary and additional supplies were delivered to him. The individual cafeterias did not do any cooking on *43 a major scale. They kept warm the cooked foods that were delivered to them from the commissaries. They did short-order cooking, such as the frying of hamburgers, and ham and eggs. 2 No real cooking, as such, was done in the cafeterias. No major food items were cooked on the premises of the cafeterias.
*259 In the period 1927 to 1939, commissaries were maintained and operated by Waldorf Division in the cities of Springfield, Worcester, and Boston, Massachusetts; New Haven, Connecticut; Albany, Syracuse, Rochester, New York City, Buffalo, New York; and Providence, Rhode Island. The expenses of operating the commissaries were allocated to the individual cafeterias on the basis of dollar sales.
Waldorf Division carefully watched the activities*44 of its competitors. It engaged "shoppers" who ate in competing cafeterias, and it required all of its supervisors to eat one or two meals each week in competitors' cafeterias and render weekly reports to Boston headquarters. These records were kept at headquarters, together with records of temperatures, conventions in a particular city, and other pertinent information, for a period of 5 or 6 years, or more.
Competitors: Industry.
The petitioner had a number of competitors in the field in which it operated. Among these were the John R. Thompson Company (hereinafter referred to as Thompson's), Bickford's, Inc., Childs Company, and Horn & Hardart Company. The Horn & Hardart Company operated a chain of restaurants in New York City. Horn & Hardart Baking Company of Philadelphia operated a chain of restaurants in Philadelphia. Unless otherwise distinguished, both will be referred to herein as Horn & Hardart. All were competitors in a low-price field. Childs' prices were slightly higher due to the fact that it gave table service. The several companies mentioned were in competition with each other. The competition consisted in that each operated in the same general manner, that*45 is, they have centralized buying management and central commissaries in which the major cooking is performed. All operate chains of restaurants. Bickford's and Thompson's are Waldorf's principal competitors. The Horn & Hardart companies operate only in New York and Philadelphia. 3
*46 Base Period Depression -- Waldorf's Profits Cycle.
In the latter part of 1929, following the break in the stock market, wholesale food prices began to drop. The weighted index numbers of *260 all foods, on yearly averages (using 1926 as 100), for 1926 and succeeding years through the base period, were as follows:
| 1926 | 100.0 |
| 1927 | 96.7 |
| 1928 | 101.0 |
| 1929 | 99.9 |
| 1930 | 90.5 |
| 1931 | 74.6 |
| 1932 | 61.0 |
| 1933 | 60.5 |
| 1934 | 70.5 |
| 1935 | 83.7 |
| 1936 | 82.1 |
| 1937 | 85.5 |
| 1938 | 73.6 |
| 1939 | 70.4 |
Retail prices, as shown by average sales to customers, in Waldorf Division's restaurants did not drop as rapidly as wholesale food prices beginning in 1929, nor were they advanced as rapidly as wholesale food prices beginning in 1933. The following tabulation shows average sales to customers in Waldorf's principal subdivisions from 1926 through 1939:
| Albany & | Boston | Springfield | |
| Year | Buffalo | Lowell & | & New York |
| Divisions | Providence | Divisions | |
| Divisions | |||
| 1926 | 29.6 cents | 29.3 cents | 28.3 cents |
| 1927 | 29.3 | 29.8 | 28.8 |
| 1928 | 29.2 | 28.1 | 28.4 |
| 1929 | 29.4 | 28.0 | 29.2 |
| 1930 | 28.5 | 27.6 | 28.8 |
| 1931 | 26.5 | 26.2 | 26.9 |
| 1932 | 24.0 | 24.0 | 24.2 |
| 1933 | 23.0 | 22.8 | 23.1 |
| 1934 | 23.5 | 23.3 | 23.4 |
| 1935 | 23.4 | 23.2 | 23.4 |
| 1936 | 23.8 | 23.4 | 23.5 |
| 1937 | 24.1 | 23.5 | 23.6 |
| 1938 | 24.0 | 23.1 | 23.3 |
| 1939 | 23.9 | 23.5 | 23.6 |
*47 During the depression following the stock market break in 1929, chain restaurant operators were able to purchase food at favorable prices. Waldorf and other chains did not drop their retail prices ratably with the drop in wholesale prices because there was no certainty that the bottom in prices had been reached, and they did not want to be in the position of having to raise prices in their restaurants if wholesale prices did increase. However, the lowering food costs enabled them to reduce prices to the extent that they were able to attract new customers. Such new customers, some of whom had been accustomed to eating in higher priced restaurants, replaced those who because of loss of jobs were no longer financially able to eat in restaurants.
The income, cost of sales, expenses, and result of operations of the Waldorf Division for the years 1922 to 1939, inclusive, expressed in round figures, were as follows: *261
| Other income | ||||||
| Cost of | Gross profit | Gross profit | ||||
| Year | Sales | sales * | on sales | Profits on | Interest | on sales |
| Industrial | discounts | plus other | ||||
| Division | and miscel. | income | ||||
| 1922 | $ 10,368,569 | $ 7,837,373 | $ 2,531,195 | $ 18,080 | $ 88,901 | $ 2,638,176 |
| 1923 | 11,799,200 | 9,185,742 | 2,613,458 | 50,358 | 77,692 | 2,741,508 |
| 1924 | 11,211,457 | 8,565,095 | 2,646,362 | 23,835 | 59,446 | 2,729,643 |
| 1925 | 10,710,748 | 8,127,618 | 2,583,130 | 13,301 | 72,760 | 2,669,191 |
| 1926 | 11,257,854 | 8,380,593 | 2,877,261 | 9,512 | 86,264 | 2,973,037 |
| 1927 | 11,148,814 | 8,357,085 | 2,791,729 | 14,917 | 68,036 | 2,874,682 |
| 1928 | 10,814,000 | 8,098,675 | 2,715,325 | 17,361 | 73,889 | 2,806,575 |
| 1929 | 11,395,510 | 8,339,403 | 3,056,107 | 38,141 | 57,330 | 3,151,577 |
| 1930 | 10,976,693 | 7,814,275 | 3,162,418 | 45,807 | 43,984 | 3,252,209 |
| 1931 | 10,866,467 | 7,632,503 | 3,233,964 | 15,210 | 47,473 | 3,296,647 |
| 1932 | 9,971,430 | 7,089,306 | 2,882,124 | (1,082) | 32,953 | 2,913,995 |
| 1933 | 9,395,276 | 6,965,803 | 2,429,472 | 6,000 | 31,165 | 2,466,638 |
| 1934 | 9,546,072 | 7,169,780 | 2,376,292 | (2,210) | 33,150 | 2,407,232 |
| 1935 | 9,868,516 | 7,370,089 | 2,498,427 | (2,856) | 33,395 | 2,528,967 |
| 1936 | 10,573,385 | 7,743,145 | 2,830,240 | 39,532 | 2,869,772 | |
| 1937 | 10,681,266 | 8,208,027 | 2,473,239 | 43,013 | 2,516,252 | |
| 1938 | 10,054,539 | 7,703,910 | 2,350,629 | 22,430 | 2,373,059 | |
| 1939 | 10,323,160 | 7,881,554 | 2,441,606 | 47,510 | 2,489,116 |
| Net expenses | Administrative | Total | |
| Year | relating to | and | occupancy |
| occupancy * | other | and | |
| expenses | adm. expense | ||
| 1922 | $ 923,287 | $ 545,101 | $ 1,468,388 |
| 1923 | 1,056,725 | 556,140 | 1,612,865 |
| 1924 | 1,181,289 | 481,655 | 1,662,944 |
| 1925 | 1,238,288 | 454,771 | 1,693,059 |
| 1926 | 1,364,620 | 506,406 | 1,871,026 |
| 1927 | 1,384,317 | 449,764 | 1,834,081 |
| 1928 | 1,437,544 | 473,166 | 1,910,710 |
| 1929 | 1,576,596 | 528,885 | 2,105,481 |
| 1930 | 1,541,843 | 549,817 | 2,091,660 |
| 1931 | 1,698,845 | 493,904 | 2,192,749 |
| 1932 | 1,818,116 | 401,047 | 2,219,163 |
| 1933 | 1,725,672 | 467,873 | 2,193,545 |
| 1934 | 1,691,498 | 541,499 | 2,232,997 |
| 1935 | 1,657,651 | 425,755 | 2,083,406 |
| 1936 | 1,732,902 | 524,695 | 2,257,597 |
| 1937 | 1,634,266 | 483,827 | 2,118,093 |
| 1938 | 1,719,546 | 412,976 | 2,132,522 |
| 1939 | 1,680,443 | 423,113 | 2,103,556 |
| Loss on | |||
| Net income | non-operating | ||
| Year | from store | lease | |
| operations | transferred | Net income | |
| from Ginter | |||
| Res. Co. | |||
| 1922 | $ 1,169,788 | $ 1,169,788 | |
| 1923 | 1,128,643 | 1,128,643 | |
| 1924 | 1,066,699 | 1,066,699 | |
| 1925 | 976,132 | 976,132 | |
| 1926 | 1,102,011 | 1,102,011 | |
| 1927 | 1,040,601 | 1,040,601 | |
| 1928 | 895,865 | 895,865 | |
| 1929 | 1,046,096 | 1,046,096 | |
| 1930 | 1,160,549 | 1,160,549 | |
| 1931 | 1,103,898 | 1,103,898 | |
| 1932 | 694,832 | 694,832 | |
| 1933 | 273,093 | 273,093 | |
| 1934 | 174,235 | 174,235 | |
| 1935 | 445,561 | $ 115,812 | 329,749 |
| 1936 | 612,175 | 98,273 | 513,902 |
| 1937 | 398,159 | 95,819 | 302,340 |
| 1938 | 240,537 | 122,432 | 118,105 |
| 1939 | 385,560 | 118,800 | 266,760 |
Averages:
| Gross profit | |||
| Year | Sales | Cost of sales | on sales |
| 1922-1939 | $ 10,609,053 | $ 7,914,999 | $ 2,694,054 |
| 1922 1935 | 10,666,472 | 7,923,810 | 2,742,662 |
| 1929-1934 | 10,358,575 | 7,501,845 | 2,856,730 |
| 1936-1939 | 10,408,088 | 7,884,159 | 2,523,928 |
| Other income | |||
| Gross profit | |||
| Year | Profits on | Interest | on sales plus |
| industrial | discounts and | other income | |
| Division | miscellaneous | ||
| 1922-1939 | $ 13,687 | $ 53,274 | $ 2,761,015 |
| 1922 1935 | 17,598 | 57,603 | 2,817,863 |
| 1929-1934 | 16,978 | 41,009 | 2,914,717 |
| 1936-1939 | 38,121 | 2,562,049 |
| Total | |||
| Net expenses | Administrative | occupancy | |
| Year | relating to | and other | and |
| occupancy | expenses | administrative | |
| expense | |||
| 1922-1939 | $ 1,503,525 | $ 484,466 | $ 1,987,991 |
| 1922 1935 | 1,449,735 | 491,128 | 1,940,863 |
| 1929-1934 | 1,675,428 | 497 171 | 2,172,599 |
| 1936-1939 | 1,691,789 | 461,152 | 2,152,941 |
| Loss on | |||
| Net income | non-operating | ||
| Year | from store | lease | |
| operations | transferred from | Net income | |
| Ginter Res. | |||
| Co. | |||
| 1922-1939 | $ 773,024 | $ 30,619 | $ 742,405 |
| 1922 1935 | 877,000 | 8,272 | 868,728 |
| 1929-1934 | 742,118 | 742,118 | |
| 1936-1939 | 409,108 | 108,831 | 300,277 |
| Social | Other | Total | |||
| Year | Provisions, | Labor | security | cost of | cost of |
| etc. | tax | sales | sales | ||
| 1922 | $ 5,190,285 | $ 1,781,912 | $ 865,177 | $ 7,837,373 | |
| 1923 | 6,088,510 | 2,097,960 | 999,272 | 9,185,742 | |
| 1924 | 5,545,163 | 2,034,388 | 985,544 | 8,565,095 | |
| 1925 | 5,296,011 | 1,872,210 | 959,398 | 8,127,618 | |
| 1926 | 5,371,299 | 1,996,170 | 1,013,124 | 8,380,593 | |
| 1927 | 5,322,550 | 2,071,665 | 962,870 | 8,357,085 | |
| 1928 | 5,106,737 | 2,029,368 | 962,570 | 8,098,675 | |
| 1929 | 5,441,134 | 2,095,766 | 802,503 | 8,339,403 | |
| 1930 | 4,984,162 | 2,104,311 | 725,801 | 7,814,275 | |
| 1931 | 4,789,438 | 2,041,629 | 801,437 | 7,632,503 | |
| 1932 | 4,464,425 | 1,843,298 | 781,584 | 7,089,306 | |
| 1933 | 4,458,816 | 1,796,234 | 710,753 | 6,965,803 | |
| 1934 | 4,560,790 | 1,876,918 | 732,072 | 7,169,780 | |
| 1935 | 4,793,426 | 1,874,835 | 701,828 | 7,370,089 | |
| 1936 | 5,067,521 | 1,953,284 | $ 33,362 | 688,978 | 7,743,145 |
| 1937 | 5,160,702 | 2,202,341 | 106,326 | 738,658 | 8,208,027 |
| 1938 | 4,589.094 | 2,240,705 | 141,340 | 732,770 | 7,703,910 |
| 1939 | 4,733,335 | 2,282,432 | 142,535 | 723,252 | 7,881,554 |
| Averages: | |||||
| 1922-1939 | 5,053,522 | 2,010,857 | 23,531 | 827,088 | 7,914,999 |
| 1922-1935 | 5,100,910 | 1,965,476 | 857,424 | 7,923,810 | |
| 1929-1934 | 4,783,128 | 1,959,693 | 759,025 | 7,501,845 | |
| 1936-1939 | 4,887,663 | 2,169,691 | 105,891 | 720,915 | 7,884,159 |
*51 The number of customers of Waldorf Division, in each case not including the industrial division, for the years 1922 to 1939 were as follows:
| Waldorf | |
| Year | Division |
| 1922 | 38,511,895 |
| 1923 | 42,153,229 |
| 1924 | 39,966,447 |
| 1925 | 37,684,690 |
| 1926 | 38,582,702 |
| 1927 | 38,541,013 |
| 1928 | 38,098,722 |
| 1929 | 40,044,936 |
| 1930 | 39,243,361 |
| 1931 | 41,058,433 |
| 1932 | 41,521,236 |
| 1933 | 41,005,551 |
| 1934 | 40,871,550 |
| 1935 | 42,372,836 |
| 1936 | 44,984,546 |
| 1937 | 45,212,329 |
| 1938 | 43,142,935 |
| 1939 | 43,769,130 |
The index of income of all corporations that filed returns in the period 1922 to 1939, using 100 as the index for the entire period, reached a high 191.4 in 1929. In 1930 it was 89.8, in 1931 it was 16.9, and in 1932 it was minus 22.4, which was the depth of the depression that began in 1929. The index figures for the years 1933 to 1939, inclusive, are as follows:
| 1933 | 13.5 |
| 1934 | 49.3 |
| 1935 | 69.4 |
| 1936 | 104.4 |
| 1937 | 103.8 |
| 1938 | 62.8 |
| 1939 | 102.4 |
The period 1922 to 1929 was one of expansion and prosperity for the chain restaurant business, particularly that of cafeterias. Operators were picking better locations, paying higher rents, and improving *263 the appearance, equipment, and methods of operation*52 of cafeterias.
During the early years of the depression, the low-priced chain restaurants fared well in relation to other businesses. Figures as to John R. Thompson Co. for the years 1928 to 1931, inclusive, are as follows:
| Number of | ||||
| Year | Gross sales | Net earnings | Customer | restaurants |
| before taxes | count | at end of | ||
| each year | ||||
| 1928 | $ 14,585,049.74 | $ 1,334,706.67 | 62,354,564 | 124 |
| 1929 | 14,541,533.41 | 1,325,641.94 | 61,356,799 | 120 |
| 1930 | 13,725,296.77 | 1,148,891.15 | 58,763.752 | 119 |
| 1931 | 13,457,037.56 | 1,019,531.49 | 62,373,215 | 115 |
The records of Bickford's Inc., for the years 1929 to 1932, inclusive, show the following results:
| Year | Sales, food | Profit from | Check average |
| only | operations | ||
| 1929 | $ 4,411,896.74 | $ 583,403.80 | .2598 |
| 1930 | 4,960,148.52 | 728,932.07 | .2420 |
| 1931 | 5,054,667.40 | 665,596.95 | .2420 |
| 1932 | 4,596,447.42 | 418,180.18 | (not shown) |
Figures as to sales of other chain restaurants are:
| Year | B/G | Pig'n Whistle | Horn & Hartdart |
| (N. Y.) | |||
| 1929 | $ 3,404,523 | $ 3,671,248 | $ 17,436,155 |
| 1930 | 3,405,992 | 3,996,420 | 18,592,797 |
| 1931 | 2,883,200 | 3,688,340 | 19,143,521 |
| 1932 | 2,151,192 | 2,670,019 | 17,294,947 |
The number*53 of food checks issued to customers of low-priced chain restaurants, as far as available, remained relatively constant in the early depression years. The figures as to Childs Company are as follows:
| Year | No. of | No. of food |
| restaurants | checks | |
| 1929 | 110 | 48,422,942 |
| 1930 | 112 | 46,512,429 |
| 1931 | 108 | 44,512,429 |
In the case of Waldorf System, the restaurants operated at the close of each of the same years and the customers served in each year were:
| Year | No. of stores | No. of |
| Customers | ||
| 1929 | 156 | 51,752,459 |
| 1930 | 162 | 52,395,677 |
| 1931 | 167 | 54,157,538 |
*264 Average net income of Waldorf Division for the years 1930, 1931, and 1932 was $ 986,426.
The index of net income of 6 chain restaurants operating in the low-priced field was 114.9 for the years 1929 to 1933 as compared with an index of 100 for the period 1923 to 1939. 4
*54 Wholesale food prices began to rise in 1933. The rise on an annual basis first shows up in figures for 1934. In 1933 the weighted index number of all foods was 60.5 (on the basis of a figure of 100 for 1926); in 1934 it was 70.5, and in 1935 it was 83.7. Low-priced restaurant chains were not able to increase their retail prices to keep pace with the increase in wholesale prices due to several factors. One of these was customer resistance to any increase in prices. Any increase by Waldorf Division in the price of an article on its menu resulted in decreased sales, complaints, letters, and telephone calls. Price increases could be made without loss of sales only after the consumer public had become educated as to the market costs of commodities. Such resistance continued from 1933 to 1939, inclusive.
The low-priced restaurant chains customarily sell food items in multiples of 5 cents, as their customers object to paying odd cents, and on a rising market Waldorf Division often found it necessary to absorb increased costs of odd cents per order until there came a time when it felt that the price at the counter could be increased by a full 5 cents. On what were known as fast selling*55 items, such an increase in price would often result in a decrease of sales of anywhere from 40 to 60 per cent.
During the period following 1933, labor costs increased substantially. Workers in Waldorf Division and othter chain restaurants were paid higher wages which the operators found it difficult to pass on to customers. Under the National Recovery Act, the hours of Waldorf Division's employees were shortened and their minimum wage levels raised which resulted in increased labor costs in 1933 of $ 125,000. Compliance with provisions of the Restaurant Code in 1934 resulted in a material increase in the cost of labor. In 1936 wages of all Waldorf employees, except supervisors and executives, were raised 10 per cent. In the years immediately preceding 1939, the average hourly wage of Waldorf Division's employees increased by more than 23 per cent, and wage and hour adjustments added over $ 600,000 to its annual payrolls. Social Security taxes averaged $ 105,891 in the period 1936 to 1939.
The result of increased food costs and operating costs, and the inability of operators to pass on the increased costs to customers, was that many low-priced chains ran into financial difficulties*56 in the period *265 1933 to 1939. Some went out of business completely and others were forced to reorganize. The number of business failures among such chains during that period was greater than in the whole prior history of the business.
The net income of Waldorf Division, Waldorf System, Inc., with its affiliated corporations on a consolidated basis, of the five restaurant chains above mentioned shown separately and also combined with the income of Waldorf System, and the income of all corporations, are shown in the tabulation below. The dollar amount in each case is net income before taxes, less tax-exempt income, plus interest paid:
| Waldorf System | |||
| Year | Waldorf | Incorporated | Five restaurant |
| Division | (Consolidated) | chains | |
| 1923 | $ 1,161,729 | $ 1,404,554 | $ 6,098,477 |
| 1924 | 1,105,276 | 1,360,049 | 7,333,183 |
| 1925 | 1,018,825 | 1,213,719 | 7,032,282 |
| 1926 | 1,159,030 | 1,336,393 | 8,622,080 |
| 1927 | 1,092,093 | 1,309,281 | 8,162,350 |
| 1928 | 961,118 | 1,179,545 | 8,032,539 |
| 1929 | 1,108,741 | 1,392,328 | 8,771,691 |
| 1930 | 1,219,600 | 1,445,118 | 8,293,661 |
| 1931 | 1,164,500 | 1,252,904 | 7,695,851 |
| 1932 | 753,388 | 664,640 | 4,435,032 |
| 1933 | 332,953 | 128,217 | 2,447,536 |
| 1934 | 221,418 | 51,272 | 2,750,155 |
| 1935 | 371,025 | 421,551 | 1,944,534 |
| 1936 | 556,468 | 729,670 | 4,061,755 |
| 1937 | 335,039 | 487,945 | 1,446,711 |
| 1938 | 140,772 | 202,209 | 2,623,821 |
| 1939 | 288,821 | 401,787 | 3,344,015 |
| Computed average: | |||
| 1923-35 | 897,669 | 1,012,275 | 6,278,413 |
| 1923-39 | 764,164 | 881,246 | 5,476,216 |
| 1936-39 | 330,275 | 455,403 | 2,869,075 |
| Five restaurant | ||
| Year | chains & | All corporations |
| Waldorf | ||
| Consolidated | ||
| 1923 | $ 7,503,031 | $ 9,586,000,000 |
| 1924 | 8,693.232 | 8,808,000.000 |
| 1925 | 8,246,001 | 11,238,000.000 |
| 1926 | 9,958,473 | 11,493,000,000 |
| 1927 | 9,471,631 | 10,885,000,000 |
| 1928 | 9,212,084 | 12,808,000,000 |
| 1929 | 10,164,019 | 13,665,000,000 |
| 1930 | 9,738,779 | 6,413,000,000 |
| 1931 | 8,948,755 | 1,204,000,000 |
| 1932 | 5,099,672 | (1,600,000,000) |
| 1933 | 2,575,753 | 964,000,000 |
| 1934 | 2,801,427 | 3,516,000,000 |
| 1935 | 2,366,085 | 4,957,000,000 |
| 1936 | 4,791,425 | 7,451,000,000 |
| 1937 | 1,934,656 | 7,410,000,000 |
| 1938 | 2,826,030 | 4,479,000,000 |
| 1939 | 3,745,802 | 7,306,000,000 |
| Computed average: | ||
| 1923-35 | 7,290,688 | 7,226,000,000 |
| 1923-39 | 6,357,462 | 7,093,000,000 |
| 1936-39 | 3,324,478 | 6,662,000,000 |
Expressing the above dollar amounts in index figures on the basis of the index figure for 1923 to 1939 being 100, gives the following results:
| Waldorf System | |||
| Year | Waldorf | Incorporated | Five restaurant |
| Division | (Consolidated) | chains | |
| 1923 | 152.0 | 159.4 | 111.3 |
| 1924 | 144.6 | 154.3 | 133.9 |
| 1925 | 133.3 | 137.7 | 128.4 |
| 1926 | 151.7 | 151.6 | 157.4 |
| 1927 | 142.9 | 148.6 | 149.1 |
| 1928 | 125.8 | 133.8 | 146.7 |
| 1929 | 145.1 | 158.0 | 160.2 |
| 1930 | 159.6 | 164.0 | 151.4 |
| 1931 | 152.4 | 142.2 | 140.5 |
| 1932 | 98.6 | 75.4 | 81.0 |
| 1933 | 43.6 | 14.5 | 44.7 |
| 1934 | 29.0 | 5.8 | 50.2 |
| 1935 | 48.6 | 47.8 | 35.5 |
| 1936 | 72.8 | 82.8 | 74.2 |
| 1937 | 43.8 | 55.4 | 26.4 |
| 1938 | 18.4 | 22.9 | 47.9 |
| 1939 | 37.8 | 45.5 | 61.1 |
| Computed average: | |||
| 1923-35 | 117.5 | 114.9 | 114.6 |
| 1923-39 | 100 | 100 | 100 |
| 1936-39 | 43.2 | 51.7 | 52.4 |
| Five restaurant | ||
| Year | chains | All corporations |
| & Waldorf | ||
| Consolidated | ||
| 1923 | 118.0 | 135.1 |
| 1924 | 136.7 | 124.2 |
| 1925 | 129.7 | 158.4 |
| 1926 | 156.6 | 162.0 |
| 1927 | 149.0 | 153.5 |
| 1928 | 144.9 | 180.6 |
| 1929 | 159.9 | 192.7 |
| 1930 | 153.2 | 90.4 |
| 1931 | 140.8 | 17.0 |
| 1932 | 80.2 | (22.6) |
| 1933 | 40.5 | 13.6 |
| 1934 | 44.1 | 49.6 |
| 1935 | 37.2 | 69.9 |
| 1936 | 75.4 | 105.0 |
| 1937 | 30.4 | 104.5 |
| 1938 | 44.5 | 63.1 |
| 1939 | 58.9 | 103.0 |
| Computed average: | ||
| 1923-35 | 114.7 | 101.9 |
| 1923-39 | 100 | 100 |
| 1936-39 | 52.3 | 94.9 |
*266 General Business Cycle.
There was a relatively short business depression in the United States in 1921. Thereafter, and into 1929, business conditions generally were rising. Security and commodity prices rose. Production, sales, employment, loans, debts, and interest rates were rising. There was a good deal of capital expansion in industry and of buying durable goods. Towards the end of the period, prices began to level and inventories began to accumulate to a rather unhealthy amount. In September 1929 the securities' market crashed. Immediately sales of durable goods and investments in plant and equipment fell off. This was followed by slumps in sales of other goods, *59 and production and employment decreased. This condition continued through 1930 and 1931. The low point in production was reached in 1932, and the low point in employment in 1933. There were many bankruptcies. Debts were scaled down and interest rates were lowered. Plants and equipment and durable goods wore out in the period 1929 to 1933. In 1933 and 1934 consumers started to spend on durable goods and industry started to invest in plants and equipment. Prices started to rise. Earnings of all corporations were on the plus side in 1933 and continued a steady rise through 1937. In 1938 there was a recession, but in 1939 earnings had risen to almost the 1937 level.
Ultimate Facts.
The operation of chain restaurants, such as Waldorf Division, Thompson's, Bickford's, Childs, Horn & Hardart, with a substantial number of units, centralized management, central commissaries, and purveying of food at the lowest price possible consistent with operating at a profit, constitutes an industry of which Waldorf Division was a member in the base period and in the excess profits tax years.
The business of Waldorf Division was depressed during the base period by reason of conditions generally*60 prevailing in the industry of which it was a member.
The petitioner was subjected to a profit cycle differing materially in length and amplitude from the general business cycle.
A fair and just amount representing the average of normal income during the base period years is $ 782,092.90.
OPINION.
The petitioner claims relief from excess profits tax under the provisions of Code sections 722 (a) and (b) (3) (A). Subsection (a) states the general rule as to relief if the tax is excessive and discriminatory and if the taxpayer establishes a fair and just amount representing normal earnings.
*267 Subsection (b) (3) (A) provides that the tax shall be considered excessive and discriminatory if --
(3) the business of the taxpayer was depressed in the base period by reason of conditions generally prevailing in an industry of which the taxpayer was a member, subjecting such taxpayer to
(A) a profits cycle differing materially in length and amplitude from the general business cycle * * *
On the basis of the facts found we conclude that the tax here involved was excessive and discriminatory and that petitioner is entitled to relief under the provisions of the above quoted section of*61 the Code. This section is commonly referred to as the variant profits cycle provision. In order to qualify under this provision, a taxpayer must establish a number of factors. It must establish (a) that its business was depressed in the base period; (b) that it was a member of an industry; (c) that the depression in its business was due to conditions generally prevailing in its industry; and (d) that the foregoing factors subjected the taxpayer to a profits cycle differing materially in length and amplitude from the general business cycle.
The petitioner has undertaken to establish that it meets all of the above qualifying factors. At the outset, it should be noted that by the very nature of the provisions of subsection (b) (3) (A), consideration of any case claiming relief thereunder can not be confined to the base period as is true under other subsections. The provision as to depression in the base period requires comparison with prior years; the provision as to comparison of cycles requires consideration of factors over a longer period of time than the base period. Commissioner's Bulletin on Section 722, Part IV (B).
Base Period Depression.
It is obvious from the figures*62 in evidence that the business of the petitioner was depressed in the base period in relation to its business in prior periods. The average excess profits net income of Waldorf Division for each of several periods in the history of its operations was as follows:
| 1922-1935 | $ 868,727.99 |
| 1922-1939 | 742,405.44 |
| 1936-1939 (base period) | 5 300,276.50 |
The net profits of Waldorf Division and its four affiliated corporations on a consolidated basis for the same period were as follows:
| 1922-1935 | $ 986,810.00 |
| 1922-1939 | 862,044.50 |
| 1936-1939 (base period) | 425,364.93 |
*268 Industry.
The parties differ sharply as to whether or not the chain restaurant business, in which Waldorf Division was engaged, constituted an industry within*63 the meaning of subsection (b)(3). Regulations 112, section 35.722-2 (b)(8), on this subject, read in part:
In general an industry may be said to include a group of enterprises engaged in producing or marketing the same or similar products or services under analogous conditions which are essentially different from those encountered by other enterprises. * * *
Commissioner's Bulletin on Section 722, Part I (F), provides in part:
In most general terms an "industry" comprises a group of business concerns sufficiently homogeneous in nature of production or operation, type of product or service furnished, and type of customers, so as to be subject to roughly the same external economic circumstances affecting their prices, volume and profits. * * *
Without approving or disapproving the above definitions, we think that a holding that the low-priced restaurant chain business constitutes an industry does not do violence to them. The chain restaurants, similar to those of Waldorf Division, operate entirely differently from other types of eating places. Among the distinguishing features was centralized purchasing, with a constant survey of commodity markets to enable them to buy at the*64 lowest possible prices. The purchase of food in large quantities for cash enables them to buy at prices generally lower than other types of restaurants. Menus are prepared by the headquarters' office, and are limited as to the number of food items offered. Perhaps the most striking difference is that food is prepared in central commissaries and sent to the individual restaurants ready to be served from the steam table or counter. No cooking is done in the restaurants except for short orders. Thus, the kitchen equipment in a chain restaurant is meager compared with that of other types of restaurants. The restaurants similar to those of Waldorf Division featured low individual food checks based on their policy of furnishing food at the lowest possible price consistent with making a profit. There is testimony that among business people acquainted with the restaurant business, the operation of the low-priced chains was regarded as an industry separate and distinct from that of other types of eating establishments.
Upon consideration of all the evidence, we are satisfied that the operation of chain restaurants of a type similar to those of Waldorf Division constituted an industry*65 within the meaning of Code section 722 (b) (3) and that the Waldorf Division of the petitioner was a member of that industry.
*269 Conditions in the Industry.
One of the elements of section 722 (b) (3) is that the taxpayer's business was depressed in the base period by reason of conditions generally prevailing in its industry.
The evidence leaves no doubt that the business of the petitioner was depressed in the base period in relation to prior years. The average excess profits net income of Waldorf Division in the base period was only $ 300,276 as contrasted to $ 868,727 in the period 1923 to 1935, and $ 742,405 over the entire period 1923 to 1939. The earnings of the petitioner and its subsidiaries on a consolidated basis averaged only $ 455,403 in the base period, whereas they had averaged $ 1,012,275 in the period 1923 to 1935 and $ 881,246 in the period 1923 to 1939.
The evidence likewise leaves no doubt that the business of other restaurant chains was similarly depressed. It is shown that the average earnings of five representative chains, other than the petitioner, were $ 2,869,075 in the base period, contrasted with $ 6,278,413 for the period 1923 to 1935, and $ *66 5,476,216 over the longer period 1923 to 1939.
On an index basis, using 100 for the period 1923 to 1939, the earnings of Waldorf Division were 117.5 for 1923 to 1935 and only 43.2 in the base period. The index of earnings of the five representative chains was 114.6 in 1923 to 1935 and only 52.4 in the base period.
The evidence is not limited to figures as to the petitioner and the five representative chains. There is testimony that establishes that the depressed condition of business in the base period existed generally among low-priced restaurant chains, and a number of similar chains were either forced to reorganize or were liquidated. A witness for the petitioner, who has been familiar with the restaurant business for over 30 years and whose corporation has been dealing with restaurants over a longer period, testified that in and immediately prior to the base period the number of failures in the chain restaurant industry was larger than in any period in the previous 50 years.
The evidence adequately shows the reasons for similarity of conditions in the petitioner's business and of those generally prevailing in its industry. All members of the industry were affected by the same*67 factors. The chains had to pay increased prices for food, but were unable simultaneously to increase the prices that they charged because of consumer resistance. Other costs, particularly that of labor, increased substantially and such increases could not immediately be passed on to customers of the chains.
We conclude that the business of Waldorf Division was depressed in the base period because of conditions that generally prevailed in its industry.
*270 Cycle Question.
The most difficult phase of this case is whether the petitioner meets the variant profits cycle test. In the language of the Code, the taxpayer must have been subjected to "* * * a profits cycle differing materially in length and amplitude from the general business cycle."
The case has been tried on the theory that a business cycle is a period of business activity which includes four phases, namely, a period of prosperity, one of recession, one of depression, and one of revival. A complete cycle is measured from a period of prosperity to another period of prosperity, or from a period of depression to another period of depression. The Bulletin on Section 722, Part IV (B), provides that "the general business*68 cycle must be defined as the profits cycle of all corporations."
Accepting the above definitions for the purposes of this case, the stipulated figures indicate that for all corporations the period 1923 to 1939 represents a profits cycle. The years 1923 to 1929 were a period of prosperity when the index of income went from 135.1 to 192.7. The year 1930 can be said to be one of recession when the index dropped to 90.4. The years 1931 and 1932 were depression years when the indexes were 17.0 and minus 22.6, respectively. The period 1933 to 1939 was one of revival when the index rose from 13.6 to 103.0, with a temporary recession in 1938. The evidence in this case is to the effect that for cycle study purposes short-term movements, such as the recession in 1938, are ignored. In contrast, Waldorf Division's period of prosperity ran from 1923 through 1930 during which its index figures ranged from a low of 125.8 to a high of 159.6. It might with reason be said that the period of prosperity included the year 1931, as in that year the index was only 7.2 points lower than in the preceding year. The year 1932 was one of recession when the index figure dropped to 98.6. Its depression*69 years were 1933 and 1934 when the indexes dropped to 43.6 and 29.0, respectively. Its recovery period did not start until 1935 when the index rose to 48.6. The recovery period lasted only through 1936 when the index again rose and was 72.8. Then another recession set in and lasted through the 3 succeeding years. It is thus seen that except for the early years of the period 1923 to 1939, Waldorf's periods of prosperity, recession, and depression did not coincide with those of all corporations.
If we consider the "peak to peak" years as measuring a profits cycle, there is again a lack of coincidence. The first peak for all corporations was in 1929 when the index was 192.7, while Waldorf's did not occur until 1930 when its index was 159.6. The low point for all corporations was in 1932, whereas Waldorf's did not occur until 2 *271 years later in 1934. On the rising side, all corporations again reached a recognized peak in 1939. In contrast, Waldorf did not reach a peak in any year that marked the rise for all corporations. It had reached a temporary high point in 1936 when its index was 72.8, but in the 2 succeeding years its earnings dropped drastically to a low of 18.4*70 in 1938, and by 1939 the index had risen only to 37.8. Even if we consider 1936 as Waldorf's second peak, the result is that its first peak occurred 1 year later than that of all corporations, and its second peak was 3 years earlier. This difference in time in this short span of years marks a material difference in length of the cycles.
Little need be said as to the difference in amplitude of the cycles. The index figures make it clear that there was a marked difference in that respect. The contrast is sharp in any period or year that may be selected. For example, Waldorf's index for 1923 to 1935 was 117.5 while that of the general business cycle as measured by the income of all corporations was 101.9. The comparison for the base period is 43.2 for Waldorf and 94.9 for all corporations. Waldorf did not have a minus index figure in any year from 1923 to 1939, whereas the index for all corporations dipped to a minus of 22.6 in 1932. If we take Waldorf's cycle as being the period 1930 to 1936, the indexes are 159.6 and 72.8, respectively. If we consider the cycle of all corporations to be the years 1929 to 1936, the indexes are 192.7 and 105, respectively. Thus, the amplitude*71 was markedly different, no matter what period be regarded as a cycle.
The similarity of the earnings pattern of Waldorf Division and that of representive industry members, as well as the dissimilarity between the earnings pattern of Waldorf and its industry on the one hand, and business in general on the other, can be demonstrated by means of a Pearsonian correlation. A Pearsonian correlation is a method of determining the tendency of things to vary together. This method is a recognized statistical device. If two quantities correlate perfectly, the coefficient of correlation is expressed as plus 1. If there is no correlation, the coefficient is zero. The closer to plus 1 (or 1.00) the coefficient of correlation is, the closer the degree of correlation. The Pearsonian coefficient of correlation does not involve averages but involves comparison of pairs of index numbers in each year.
The coefficient of correlation of Waldorf Division earnings for the period 1923 to 1939 compared with the aggregate earnings of Thompson's, Childs, Bickford's, and the two Horn & Hardart chains (hereinafter sometimes referred to as the "five chains") for the same years is plus .935, which is an unusually*72 good correlation. If the earnings of Waldorf System, Inc., are added to the earnings of the 5 chains and the combined earnings of these 6 chains compared with Waldorf Division over the years 1923 to 1939, a coefficient of correlation of plus .957 results. This is an even better correlation.
*272 Comparing the aggregate earnings of the 5 chains for the period 1923 to 1939 with earnings of all United States corporations for the same period results in a correlation coefficient of plus .377 which is an extremely poor correlation. If the earnings of Waldorf System, Inc., are added to the aggregate earnings of the 5 chains and this total compared with the earnings of all United States corporations for the same period, 1923 to 1939, the coefficient of correlation is only plus .579, which is not good. If earnings of Waldorf Division are added to the earnings of the 5 chains and this total is compared to earnings of all corporations for the period 1923 to 1939 the coefficient of correlation becomes only plus .552.
The earnings of the 5 chains and the earnings of Waldorf Division vary together during the period 1923 to 1939, and these two vary separately and distinctly from the earnings*73 of all corporations.
The chain restaurant industry lags 2 years behind all corporations so far as net earnings are concerned. This means that comparable points on the respective cycles occur 2 years later in the chain restaurant industry than for all corporations. In speaking of a 2-year lag in the chain restaurant industry, this does not mean exactly 24 months in one cycle and 24 months in the next cycle. The lag might vary a little. The description of a 2-year lag is in terms of what is reasonable and what appears to be true and the lag might be longer than 2 years.
If earnings of the 5 chains are lagged 2 years (their earnings are all pushed back by 2 years) and compared with all corporation's earnings for 1923 to 1939, then the coincidence is very marked. The coefficient of correlation in such a case is very good, being plus .818 for the years 1923 to 1939. This is so even though there are up and down movements throughout this period. Both lines on the graph tend to go upward and the lines coincide very closely. The amount of difference between the lines is very small. The amount by which either series goes up or down is very little, and generally the lines parallel each*74 other very closely. In a similar fashion, if earnings of Waldorf System, Inc., are added to those of the 5 chains and their combined earnings, with a 2-year lag, are compared with the earnings of all corporations for 1923 to 1939, the coincidence is marked. The coefficient of correlation in such a case is plus .832 for the years 1923 to 1939, which is an excellent correlation. If earnings of Waldorf Division only are added to those of the 5 chains and these earnings are lagged by 2 years and compared with earnings of all corporations, the coefficient of correlation is plus .825 for the years 1923 to 1939. The earnings of the Waldorf System taken alone and lagged 2 years produce a coefficient of correlation of .803 in comparison with the earnings of all United States corporations.
*273 A comparison of the combined earnings of Thompson's and Childs on the one hand, with the combined earnings of Waldorf Division and Clark on the other, both over the period 1923 to 1939, results in a correlation coefficient of plus .78, which is good. In a similar fashion, when combined earnings of Waldorf Division, Clark, Thompson's, and Childs over 1923 to 1939 are compared with earnings of*75 all corporations over the same period with no time lag the coefficient of correlation is plus .27, very low. If earnings of these same companies are pushed back 2 years and compared with earnings of all corporations over the period 1923 to 1939, the coefficient of correlation becomes plus .85, which is very high. If Waldorf Division and Clark's combined earnings are compared with all corporate earnings over 1923 to 1939, the correlation is plus .30 which is poor. Making the same comparison with a 2-year lag for the earnings of Waldorf and Clark results in the amazingly high correlation of plus .96.
The earnings pattern and the 2-year lag detailed above, which is characteristic of the petitioner and of the members of its industry, is attributable largely to the low price charged by the chain restaurant industry to its customers and the reaction of customers to increases and decreases in the low price. In a period of general recession the low prices charged to customers tended to maintain the customer level while food and labor costs dropped. At the same time prices to customers were lowered slowly but had a rate of decrease which was slower than costs. As a result the profits*76 of the petitioner and of its industry generally tended to increase. This was true during 1929 through 1932. On the other hand, during a period of general recovery, food, labor, and other costs increased at a more rapid rate than the prices charged to customers because of customer resistance. Sales in the meantime remained constant with a resulting decline in profits. This was true throughout the period 1933 to 1939.
The sum of these considerations is a rational and characteristic relationship between the petitioner's profit cycle and that of business in general, which considered in the light of the provisions of section 722 (a) and (b) ( 3) (A) of the Internal Revenue Code entitles the petitioner to relief, for the petitioner has met all of the tests requisite to relief imposed by that section.
Reconstruction.
We have found what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income.
The Commissioner's Bulletin on Section 722 states that the reconstruction will take the form of finding the average income of the taxpayer for another series of years than the base period which can be *274 considered as normal. *77 It further provides that in ascertaining income in other years it is desirable to use data conforming as nearly as possible to the definition of excess profits net income. Bulletin on Section 722, Part IV (C). In suggesting several figures that may be used as constructive average base period net income, the petitioner has followed the pattern of the provisions of the Bulletin. The figures proposed are taken from Exhibit 5-E attached to the stipulation which shows the excess profits net income of Waldorf Division for each year from 1922 through 1939 and the average by three groups of years.
One figure suggested is the average income for the entire period 1922 to 1939 in the amount of $ 742,405.44. It would appear that this is not a proper figure as representing normal earnings since it includes income for the period 1936 to 1939 in which we have held that the petitioner's business was depressed.
Another suggested figure is the average income for the period 1922 to 1935 in the amount of $ 868,727.99. This would also appear to be an improper figure since in the years covered by the greater part of this span Waldorf Division had its highest earnings. This factor more than outweighs*78 the fact that the period also includes the recession and depression years.
The final suggested figure is the amount of $ 782,092.90 which is the average of income for the years 1926 through 1935. The argument in support of this figure is that the period covered starts 1 year after a pit in 1925 and ends 1 year after a pit in 1934. (The indexes for 1925 and 1926 are 133.3 and 151.7, respectively, and for 1934 and 1935 they are 29.0 and 48.6). This seems like a reasonable view. The period covered includes both good and bad earnings years and is a reasonable span of time.
We think the evidence establishes all the factors requisite to qualify petitioner for relief under the above cited provisions of the statute.
The respondent stresses the point that on or about January 1, 1935, Waldorf System, Inc., (parent) assumed, as he contends, the obligations of Ginter Restaurant Company under certain real estate leases on properties in Boston and thereby sustained losses in the following amounts:
| 1935 | $ 115,812.10 |
| 1936 | 98,272.64 |
| 1937 | 95,818.94 |
| 1938 | 122,431.58 |
| 1939 | 118,799.76 |
| Average, 1936-1939 | 108,830.73 |
No findings have been made on this point. The respondent's view is that*79 the above losses are properly chargeable to Ginter rather than to Waldorf and should not be taken into consideration in determining Waldorf's income. If it be assumed that the respondent's position is *275 correct, the addition of the $ 108,830.73 to Waldorf's income for the base period would raise the average for the base period only to $ 409,107.24, instead of $ 300,276.51, which would still leave Waldorf's income depressed in relation to prior periods.
Reviewed by the Special Division.
Decisions will be entered under Rule 50.
Footnotes
1. The stipulation speaks of "stores" operated by Clark Division. Throughout the record, the words "stores" and "restaurants" are used interchangeably. The word "stores" is understood to refer to restaurants of some kind.↩
2. Quotation from page 102 of transcript:
Q. The essence of the system then, if I am correct, is you do all your preparatory work in the commissary and ship it in a ready to serve condition in your stores, is that essentially correct?
A. That is right sir. That is correct.↩
3. Bickford's, Inc., operated from 37 to 91 restaurants in the period 1929-1939. The average number operated by Horn & Hardart Baking Company was 45. Horn & Hardart Company operated from 36 to 47 restaurants. Thompson's averaged about 114 units in the period 1922-1939. The maximum number operated by Childs Company was 121 in 1927 and 1928, and thereafter the number declined until it reached 86 in 1939.
Other restaurant chains were B/G Foods, Inc., which in 1939 operated 43 units and Pig'n Whistle which operated 17 units on the West Coast.
Of all of the chains, Thompson's served the greatest number of customers. It served, in round numbers, 52,151,000 customers in 1922. The number increased until it reached the maximum of 62,373,000 in 1931, and thereafter decreased to a low of 46,532 in 1939.↩
*. See schedule below.↩
4. The 6 chains on which these figures are based are Waldorf System, Bickford's, Inc., Childs Company, Horn & Hardart Baking Company of Philadelphia, Horn & Hardart of New York, and John R. Thompson Company.↩
5. This is the stipulated figure and also appears on Exhibit 5-E. Exhibit 17-Q shows net income, less tax-exempt income, plus interest paid as averaging $ 330,275 for the base period. The difference probably lies in the fact that in Exhibit 5-E interest has not been added back.↩