*111 Decision will be entered under Rule 50.
Excess Profits Tax -- Section 722 (b) (4) Relief -- Constructive Earnings. -- Petitioner was organized and commenced business in 1938 and its business did not reach, by the end of 1939, the earning level it would have reached had it commenced business two years earlier. Held, relief should be granted. Amount of constructive average base period net income determined.
*931 The respondent has denied the petitioner's claims for refund asserted in applications for relief from excess profits tax for the calendar years 1941 to 1945, inclusive. He has also determined deficiencies in excess profits tax for the years 1943 and 1944 in the respective amounts of $ 11,512.71*112 and $ 9,160.61, the payment of which was deferred under Code section 710 (a) (5).
*932 The petition alleges error in the disallowance of claims for relief, in which relief was claimed under the provisions of Code section 722, subsections (a) and (b) (4). The specific questions for decision are whether the petitioner is entitled to the use of the push-back rule of section 722 (b) (4) and, if so, what is the amount of its constructive average base period net income.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of Pennsylvania on April 18, 1938. Its principal office is in Pittsburgh, Pennsylvania. It commenced business on April 18, 1938.
The petitioner's Federal income tax returns for all periods here involved were filed with the collector of internal revenue at Pittsburgh, Pennsylvania. It kept its books and filed its returns on the accrual method of accounting and on the calendar year basis. The petitioner filed timely applications for relief under section 722 of the Internal Revenue Code for the years 1941 to 1945, inclusive.
The petitioner was organized by John S. Forbes, who became its president and general manager. Prior to the organization*113 of the petitioner, Forbes had been treasurer of Kerotest Manufacturing Company (hereinafter called Kerotest) and was responsible for its sales in connection with commercial refrigeration and air conditioning. During the time that Forbes was with Kerotest, he had developed and patented a so called diaphragm packless valve for use in commercial refrigeration equipment, which valve was thereafter used by Kerotest.
In September 1937, Forbes applied for a patent on an improved diaphragm packless valve. A patent was granted to Forbes on January 24, 1939. This patent relates particularly to a valve designed to be used where fluids at high pressure are to be controlled and particularly fluids which are difficult to confine, such as refrigerant gases and light hydrocarbon gases.
The principal advantage of the packless valve over the packed valve previously in use was that the packless valve could be dismantled and repaired without closing the flow of the refrigerant and without having leakage into the space occupied by the refrigeration unit. Prior to the organization of the petitioner, Kerotest was the only company that manufactured a packless valve. The valve invented by Forbes and *114 on which he obtained a patent was competitive with the valve manufactured by Kerotest but sufficiently different so as not to result in infringement.
Upon incorporation of the petitioner, $ 60,000 was paid in in cash for preferred stock. Forbes turned in to the petitioner his interest in his application for a patent in exchange for 2,400 shares of common *933 stock with a par value of $ 1 per share. There was no change in the capitalization of the petitioner during the base period years. The petitioner did not manufacture its valves but purchased parts from various suppliers and assembled them into complete units for sale.
The petitioner added other items to its packless valves, which included valve parts, check valves, compressor valves, manifolds, filters, and tools.
Forbes was a leader in the refrigeration valve industry and in 1939 he was president of the Refrigeration Equipment Manufacturers Association, which was the leading trade association of the refrigeration industry.
When the petitioner commenced business, it had no backlog of orders. Its principal difficulty in the beginning was making inroads on the established companies and selling to refrigeration manufacturers*115 who were purchasing from other suppliers. The petitioner's first orders were small as customers were unwilling to switch completely from established suppliers until the petitioner's new valve was tested and proven. The petitioner was at a disadvantage in making its purchases of parts inasmuch as in the beginning its purchases were comparatively small. The petitioner's first quarters were in a basement with floor space approximately 100 feet by 175 feet. In the spring of 1940 it moved its plant to larger premises.
During the period that Forbes was with Kerotest, he had acquired many acquaintances in the commercial refrigeration field. Among these were persons connected with Commonwealth Brass Corporation, which was the petitioner's largest supplier. Commonwealth extended to the petitioner substantial amounts of credit in order to help the petitioner get started in business. The petitioner's purchases from Commonwealth in 1938 amounted to $ 40,065.20, of which it owed $ 26,198.56 at the end of the year. In 1939, the petitioner's purchases from Commonwealth amounted to $ 109,344.49, of which it owed $ 56,210.70 at the end of the year.
The petitioner's business was subject to *116 seasonal fluctuations. The commercial refrigeration business picks up about the first of March each year and a seasonal upswing continues on through the summer months. It then tapers off in the fall months of the year. Sales of commercial refrigerators and commercial refrigerator equipment during the taxable years lagged approximately one month behind the seasonal cycle of the petitioner's sales. The petitioner's sales and sales of commercial refrigerators and commercial refrigerator equipment by quarters, with adjustment for a one month lag, and the ratio of the petitioner's sales to the combined refrigerator sales for 1938 and 1939 were as follows: *934
| Petitioner's sales | |
| Year and lagged quarter | Amount |
| 1938: | |
| June, July, & Aug | $ 10,082 |
| Sept., Oct., & Nov | 17,031 |
| 1939: | |
| Dec. 1938, Jan., & Feb | 28,816 |
| Mar., Apr., & May | 50,911 |
| June, July, & Aug | 56,292 |
| Sept., Oct., & Nov | 43,358 |
| Combined sales | Ratio | |
| petitioner's | ||
| sales to | ||
| Year and calendar quarter | Amount | combined |
| sales | ||
| 1938: | ||
| 3d Quarter | $ 9,946,119 | .00101 |
| 4th Quarter | 6,654,509 | .00256 |
| 1939: | ||
| 1st Quarter | 8,093,998 | .00356 |
| 2d Quarter | 13,675,785 | .00372 |
| 3d Quarter | 9,230,863 | .00610 |
| 4th Quarter | 7,445,824 | .00582 |
*117 The commercial refrigerating equipment sales for the years 1938 and 1939 of 16 companies, including such items as water coolers, ice cream cabinets, bottle beverage coolers, milk coolers and cooling cabinets, commercial evaporators, and condensing units and condensers were as follows:
| 1938 | 1939 | |
| January | $ 1,578,144 | $ 1,059,981 |
| February | 2,153,401 | 1,346,683 |
| March | 3,742,577 | 2,489,980 |
| April | 4,502,488 | 2,951,230 |
| May | 4,020,507 | 3,160,973 |
| June | 3,506,849 | 2,801,425 |
| July | 2,416,032 | 2,037,494 |
| August | 1,969,450 | 1,593,378 |
| September | 1,579,014 | 1,251,544 |
| October | 1,109,001 | 1,336,277 |
| November | 948,487 | 1,008,352 |
| December | 1,231,504 | 1,402,165 |
| $ 28,757,454 | $ 22,439,482 |
The monthly average of sales of durable goods stores in the United States for the years 1936 to 1939, inclusive, were as follows, in millions of dollars:
| 1936 | 1937 | 1938 | 1939 |
| 816 | 907 | 734 | 865 |
The indices of industrial production of all manufacturers in the United States, adjusted for seasonal variations, for the years 1935 to 1939, inclusive, on the basis of the average for those years being 100 per cent, are as follows:
| 1935 | 87 |
| 1936 | 104 |
| 1937 | 113 |
| 1938 | 87 |
| 1939 | 109 |
| Monthly variations for 1939 | |
| January | 101 |
| February | 101 |
| March | 101 |
| April | 99 |
| May | 100 |
| June | 103 |
| July | 105 |
| August | 109 |
| September | 115 |
| October | 122 |
| November | 125 |
| December | 126 |
*118 *935 The total sales of members of the Commercial Refrigeration Manufacturers Association for the years 1936 to 1939, inclusive, were as follows:
| 1936 | 1937 | 1938 | 1939 |
| $ 14,198,170 | $ 16,704,025 | $ 14,505,345 | $ 16,006,988 |
The above sales, reduced to percentages and using sales for 1939 as 100 per cent, result in the following percentage relationship:
| Percentage | ||
| Year | Total sales | relationship |
| 1939 | $ 16,006,988 | 100.000 |
| 1938 | 14,505,345 | 90.618 |
| 1937 | 16,704,025 | 104.35 |
| 1936 | 14,198,170 | 88.7 |
The following are statistics as to the petitioner's sales, expenses and income for 1938 and 1939:
| April 18, 1938, | ||
| to | Calendar year | |
| Dec. 31, 1938 | 1939 | |
| Sales | $ 35,865.41 | $ 185,124.22 |
| Gross profit | 12,306.13 | 69,505.61 |
| Expenses | 31,620.08 | 69,554.50 |
| (19,313.95) | (48.89) | |
| Other income | 257.90 | 59.84 |
| Net income (or loss) | (19,056.05) | 10.95 |
The petitioner's excess profits credits, under the invested capital method of computation, and without application of Internal Revenue Code section 722, for the years 1940 to 1945, inclusive, were as follows:
| Year | Amount |
| 1940 | $ 4,992.00 |
| 1941 | 5,378.95 |
| 1942 | 7,726.52 |
| 1943 | 8,198.92 |
| 1944 | 14,091.88 |
| 1945 | 15,014.16 |
*119 The petitioner's excess profits net income and net income before Federal taxes for the years 1940 to 1945, inclusive, were as follows:
| Net income | ||
| Excess profits | before | |
| Year | net income | Federal taxes |
| 1940 | $ 3,077.98 | $ 3,077.98 |
| 1941 | 45,566.90 | 45,541.50 |
| 1942 | 81,762.78 | 81,265.92 |
| 1943 | 139,085.29 | 138,469.97 |
| 1944 | 141,938.02 | 140,984.70 |
| 1945 | 82,924.78 | 82,162.21 |
*936 The petitioner's tax liabilities for the years 1940 to 1945, inclusive, without the application of section 722 of the Code, were as follows:
| Declared | |||
| Year | Income tax | value excess-profits | Excess profits |
| tax | tax | ||
| 1940 | $ 457.08 | None | None |
| 1941 | 9,372.05 | None | $ 12,309.57 |
| 1942 | 3,179.45 | $ 83.55 | 61,766.45 |
| 1943 | 3,297.57 | None | 86,369.13 |
| 1944 | 6,204.26 | None | 87,680.60 |
| 1945 | 6,532.96 | None | 49,513.58 |
The petitioner's average base period net income is an inadequate standard of normal earnings because the petitioner commenced business during the base period and its business did not reach by the end of the base period the earnings level which it would have reached if the petitioner had commenced business two years before it did so. The sum of $ 19,000 would be a fair and just*120 amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based on a comparison of normal earnings and earnings during the excess profits tax years involved in this proceeding.
The petitioner, pursuant to the provisions of Internal Revenue Code section 710 (a) (5), deferred payment of excess profits taxes for the years 1943 and 1944 in the respective amounts of $ 11,512.71 and $ 9,160.61.
OPINION.
In this proceeding the petitioner seeks relief from excess profits taxes for the years 1941 to 1945, inclusive, by reason of the provisions of Internal Revenue Code section 722 (a) and 722 (b) (4).
The petitioner commenced business in April 1938, which is within the base period and which is one of the qualifying factors enumerated by the statute. Rand Beverage Co., 18 T. C. 275. It is clear to us that base period net income for the 1 year and 9 months that the petitioner operated in that period does not reflect normal operating results for the entire base period. From the first period of operations -- some nine months in 1938 -- to its first full year -- 1939 -- the petitioner's*121 business went from a deficit of some $ 19,000 to a break-even point. This, together with the testimony of witnesses, establishes to our satisfaction that the earning level of the petitioner's business would have been greater at the end of 1939 than it was if the petitioner had commenced business two years before it did. Section 722 (b) (4); Victory Glass, Inc., 17 T.C. 381">17 T. C. 381.
The respondent takes the position that the petitioner does not qualify for relief on the ground that by the end of the base period it *937 had reached the normal level of sales that it would have attained on two additional years of operation. We have set forth in the findings the figures on which this position is based. The principal figures are those showing the ratio of the petitioner's sales to the combined sales of commercial refrigerators and other commercial refrigeration equipment, by quarters, in 1938 and 1939. These figures show a steady progression of the ratio from the beginning of business in 1938 through the third quarter of 1939. From the third to the fourth quarters, the ratio sloughed off from .00610 per cent to .00582 per cent. This difference in ratio*122 is only .00028 which we think is too small a difference to negative the petitioner's evidence on this point. We accordingly hold that the petitioner has met the qualifying factors of section 722 (b) (4).
The parties seem to be in agreement as to the method of reconstruction, if the petitioner is entitled to use a constructive average base period net income. They agree that in making a reconstruction, two steps are necessary and proper: (1) determination of the normal level of earnings for the year 1939; (2) reflecting back such normal earnings over the base period years by the application of a proper index. The determination of the amount of normal earnings for 1939 is the most serious difference between the parties.
The petitioner's evidence consists in part of a mathematical projection of the volume of petitioner's sales in the seven quarters that it was in business in 1938 and 1939. Other evidence consists of the testimony of a former employee of the petitioner, and of a present officer who was not connected with the petitioner in the base period. To the sales figures thus arrived at, the petitioner applies a profit ratio of 10 per cent and then applies to that figure a business*123 index and produces a resultant figure of $ 35,489.29 as being a proper constructive average base period net income. The respondent, while not conceding that the right to reconstruction has been established, suggests that the proper starting point is to regard as normal sales an amount determined by applying to combined refrigeration sales for 1939 the petitioner's third quarter ratio of .00610 per cent. To this he then applies 3.65 per cent, which is the average ratio of earnings to sales of two corporations which the respondent says were competitors of the petitioner. To this figure, the respondent applies a business index and arrives at a constructive average base period net income of $ 7,800.
We cannot accept without qualification the proposed reconstruction of either party. The petitioner's mathematical projection has as its basis too short a period of time to reflect the normal fluctuations to be expected in business operations, particularly in the case of a new, competitive, and seasonal business. A former employee, while employed by the petitioner was not in a position of sufficient responsibility *938 in connection with sales to warrant giving full weight to his *124 sales and profits predictions. The respondent's figures we think do not adequately reflect the rate of growth of the petitioner's business in relation to the refrigeration industry or the profit margin that could reasonably be anticipated. It is our conclusion on this point that the petitioner's reconstruction is too high and the respondent's is too low to reflect normal earnings to be used as the basis for an excess profits tax credit.
We have recognized, as provided by the respondent's regulations, that no exact criteria can be prescribed for a reconstruction under section 722, Danco Co., 14 T. C. 276, 288, and that what that section calls for is a prediction and an estimate of what earnings would have been under assumed circumstances, an approximation where an absolute is not available and not expected. Victory Glass, Inc., supra, at p. 388. "The statute does not contemplate the determination of a figure that can be supported with mathematical exactness." Danco Co., 17 T. C. 1493. In our appraisal of the evidence, we have given consideration, among other things, to the facts that the *125 petitioner started business in 1938 which is recognized in all business statistics as a year of business recession, that it started from scratch with no backlog of orders, that it was in a competitive field, that it operated on credit for its materials, that it was managed by a man who was well and favorably known in the industry, and that despite its handicaps it moved steadily forward in its field of the commercial refrigeration industry. Upon consideration of the evidence offered by both parties, it is our conclusion that had the petitioner commenced business 2 years before it did, it would have reached an earning level of $ 20,000 by the end of the base period. We also think that the index represented by sales of members of the Commercial Refrigerator Manufacturers Association is a proper one to be applied for the purpose of back-casting 1939 earnings. See section 35.722-2, Regulations 112; Treasury Department Bulletin on Section 722, part V, subpart II (C) (4). We have set forth that index in the findings of fact. Its application to a 1939 earnings level of $ 20,000 produces a result of approximately $ 19,000 which we hold should be used as the petitioner's constructive average*126 base period net income for the purpose of computing its excess profits credit for the years involved in this proceeding.
The petition in these proceedings alleges error on the part of the respondent in determining that the parts of 1943 and 1944 excess profits taxes, as to which payment was deferred, constitute deficiencies. The respondent's answer denies error in this respect. Consequently, the pleadings frame an issue as to whether the respondent properly determined the amounts of the deferred payments to be deficiencies. We have held that in such cases as we have here, where there has been *939 a deferment, and claims for relief have been rejected, the amount deferred constitutes a statutory deficiency. Tribune Publishing Co., 17 T.C. 1228">17 T. C. 1228. On authority of that case, the issue framed by the pleadings is decided for the respondent.
After the above findings of fact and opinion were written but before promulgation thereof, counsel for the parties filed a supplemental stipulation of facts with respect to the issue as to the respondent's determination of deficiencies for the years 1943 and 1944. Three exhibits were filed with the supplemental*127 stipulation. One is a copy of a letter dated June 4, 1948, written by an officer of the petitioner to the collector, with which was transmitted petitioner's check in the amount of $ 20,673.32 to cover the amounts of excess profits taxes as to which payment had been deferred ($ 11,512.71 for 1943 and $ 9,160.61 for 1944). The letter contained a request that the collector credit the $ 20,673.32 "to our company in your No. 9 -- Suspense Account, until our claims under Section 722 are decided." The second exhibit is a copy of the company's check, payable to the order of the collector. The third is a collector's certificate of assessments and payments with respect to the petitioner, which certificate shows the amounts of $ 12,591.04 and $ 8,082.28 (total $ 20,673.32) for the years 1943-1944 entered in Account 9-D.
In these proceedings the petitioner deferred the payment of a portion of its excess profits tax for each of the years 1943 and 1944. The amounts so deferred, we have held above, constitute deficiencies. In 1948 when the petitioner sent to the collector its check in an amount equal to the tax deferred for the 2 years, it requested that the amount transmitted be entered in*128 the collector's suspense account and the collector did so. Apparently no assessment of the deferred amounts has been made. It would appear from the record that the amount sent to the collector in 1948 was sent by the petitioner and accepted by the collector as a deposit rather than as a payment of tax. Such deposits, it has been held, are payments in escrow and not payments of tax. Rosenman v. United States, 323 U.S. 658">323 U.S. 658. In this posture of the proceedings, it must be held that the taxes deferred, which the respondent determined were deficiencies, were not paid prior to the date of the mailing of the respondent's notice of deficiencies, which notice also contained respondent's denial of the petitioner's claims under section 722. Accordingly, we have jurisdiction to redetermine the deficiencies determined by the respondent.
In view of the disposition that we had made of the issue as to relief under section 722, the issue as to the determination of deficiencies for 1943 and 1944 based on the deferments of excess profits tax payments for those years may not be of any importance in the final disposition of these proceedings. In any event, it is*129 a matter that *940 can be determined in connection with the computations that must be made under Rule 50 of the rules of this Court.
Reviewed by the Special Division.
Decision will be entered under Rule 50.