Rand Beverage Co. v. Commissioner

Rand Beverage Company, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Rand Beverage Co. v. Commissioner

Docket No. 30250

United States Tax Court

18 T.C. 275; 1952 U.S. Tax Ct. LEXIS 196;

May 13, 1952, Promulgated

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Decision will be entered under Rule 50.

In 1937 petitioner commenced the business of producing and selling carbonated beverages. It claims relief from excess profits taxes for the years 1943, 1944, and 1945 under Code section 722 (a) and section 722 (b) (4) and (5). Petitioner's excess profits credits were computed on the invested-capital method. Held, petitioner qualifies for relief under section 722 (b) (4), but not (b) (5); that it did not reach, by the end of its base period, the earning level it would have reached if it had commenced business two years earlier; and reconstructed average base period net income determined.

E. C. Eichenbaum, Esq., and W. S. Miller, Jr., Esq., for the petitioner.

Allen Akin, Esq., for the respondent.

Rice, Judge.

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RICE

This proceeding arises from the Commissioner's disallowance of petitioner's claim for relief under section 722 (a) and 722 (b) (4) and ( 5) of the Internal Revenue Code for the calendar years 1943, 1944, and 1945 in the amounts of $ 27,836.34, $ 24,309.19, and $ 10,698.74, respectively. The question presented is whether the petitioner is entitled under such provisions of the Code to a refund of part of the excess profits taxes paid for such taxable years. Some of the facts were stipulated.

FINDINGS OF FACT.

The stipulated facts are so found and are incorporated herein.

The petitioner is a corporation with its offices and place of business in Little Rock, Arkansas. It was incorporated on February 15, 1937, under the laws of the State of Arkansas, and was authorized to manufacture and sell nonalcoholic beverages. It actually began operations in April 1937, manufacturing various soft drinks for sale.

Petitioner filed its excess profits tax returns on the calendar year basis with the collector of internal revenue for the district of Arkansas, and excess profits taxes were paid as follows:

1943	$ 32,049.24
1944	25,473.90
1945	27,691.86

Applications for relief under section 722 were duly filed; and on June 14, 1950, the respondent mailed to petitioner his notice of disallowance of said applications for relief.

Excess profits credits allowed the petitioner were based on invested capital and were in the following amounts:

1943	$ 963.27
1944	1,577.23
1945	2,755.17

In April 1937 petitioner began the sale of Cleo-Cola, a cola-flavored drink in a 12-ounce bottle. This drink was distributed in petitioner's own trucks. In May 1937 petitioner began the production of two franchised, flavored, carbonated drinks under the names of New Yorker and Town Hall. ¹ The extracts used in these drinks were acquired from the Monark Manufacturing Co. New Yorker was offered in 13 or 14 different flavors including the same flavors offered in Town Hall, and was bottled mostly in quart bottles, 12 of which constituted a case. A small quantity was bottled in 12-ounce bottles. Town Hall was offered in orange, strawberry, grape, root beer, cherry, lemon, and lemon-lime flavors, and was bottled in a pint-size bottle of which 24 constituted a case. New Yorker was distributed through the Economy Wholesale Grocery Company, owned by Roy Rand, the president of petitioner. Town Hall was distributed by delivery salesmen in petitioner's own trucks, who took the orders and delivered the merchandise to the customers. The capacity of petitioner's bottling plant was approximately 1,600,000 quarts per year during the base period.

In April 1938 petitioner ceased the production of Cleo-Cola and began the production of a different cola drink, known as Nichol-Kola, in a 12-ounce bottle.

In November 1938 petitioner began the production of a drink known as Rand's Better Beverage, produced in the same seven flavors as Town Hall, bottled in a 10-ounce size bottle, and distributed by petitioner's own trucks. This drink was made from petitioner's own formula, with the exception of the orange flavor, the extract for which was purchased from Citrus Products Co. It was a higher quality drink than Town Hall.

Petitioner promoted Nichol-Kola as a lead item, in competition with Coca-Cola, in order to build up its sale of Rand's Better Beverages, on which petitioner intended to make its profit.

Petitioner was not doing much business with Town Hall in the cities; its sales were mostly in the country. Petitioner wanted city distribution, and thought that through a smaller bottle it could maintain its country distribution and increase its city sales. It was hoped that Rand's Better Beverages would be the leading drink, and it was planned to discontinue Town Hall and to continue producing Rand's Better Beverages. Petitioner changed its advertising and repainted all of its trucks to show "Rand's Better Beverages" where "Town Hall" formerly appeared. Production of Town Hall did not stop until sometime in 1942.

Gross income and case sales of petitioner for the years 1937-1939 were as follows:

RAND BEVERAGE COMPANY, INC.
Gross Income and Case Sales
1937-1939
	1937	1938
	Gross income	Cases	Gross income	Cases
Cleo Cola	$ 11,416.64	14,426 1/2	$ 1,215.00	1,545
New Yorker:
32 ounce	8,850.10	14,750	13,631.20	22,607 1/6
12 ounce	445.00	564	104.90	133
Esquire			1,836.40	2,289 1/2
Nichol Kola:
12 ounce			12,264.20	16,121 1/2
8 ounce			932.30	1,330 1/2
Town Hall	16,102.74	20,438 1/2	38,842.20	49,568
Rand's Better Beverages			1,755.55	2,508
Miscellaneous	80.11	85	30.29
Totals	36,894.59	50,264	70,612.04	96,102 2/3

RAND BEVERAGE COMPANY, INC.
Gross Income and Case Sales
1937-1939
	1939
	Gross income	Cases
Cleo Cola
New Yorker:
32 ounce	$ 7,968.08	13,128 1/4
12 ounce	69.60	87
Esquire	393.60	492
Nichol Kola:
12 ounce	8,329.96	10,467 23/24
8 ounce	1,323.17	1,894
Town Hall	25,871.02	32,431 2/3
Rand's Better Beverages	27,533.94	39,362 23/24
Miscellaneous	12.29
Totals	71,501.66	97,863 10/12

The 2,508 cases of Rand's Better Beverages, shown in the foregoing table to have been produced in 1938, were produced in the last two months of that year.

The length of time it would require a bottling company commencing to produce soft drinks in Little Rock in 1937 to reach a normal level of earnings depended upon many factors, including efficiency of operations and merit of the product. If all factors were average and normal, it would require a period of four to five years. Such a new company would normally experience losses or subnormal earnings during the first two or three years of operation.

The experience of other bottlers in the Little Rock area indicates that with normal efficiency of management and quality of product, petitioner could reasonably have expected to increase the sale of its leading flavor drink by an over-all percentage of 27.5 per cent in the first year after 1939, and to effect an additional 23.6 per cent in the second year after 1939, under conditions as they existed on December 31, 1939.

Petitioner's profit and loss statements for the calendar years 1937, 1938, and 1939, are as follows:

RAND BEVERAGE COMPANY
Profit and Loss Statement
Income:	1937	1938	1939
Sales	$ 36,894.59	$ 70,612.04	$ 71,501.66
Cost of Goods Sold	13,659.38	23,044.97	21,337.07
Gross Profit	$ 23,235.21	$ 47,567.07	$ 50,164.59
Expenses:
Factory Labor	3,100.64	5,622.73	5,480.77
Manufacturing Expenses:
Rent	650.00	805.00	780.00
Light and Power	841.77	1,064.31	988.82
Fuel	246.36	319.69	219.33
Water	929.29	1,151.93	1,026.76
Machinery Repairs	310.37	155.09	359.24
Insurance	43.21	64.06	49.84
Factory Supplies	223.54	420.17	379.64
Building Repairs	84.84	110.60	18.32
General Factory Expense	54.15	23.51	4.85
Depreciation -- Buildings	278.03	392.48	392.52
Depreciation -- Machinery	542.69	878.12	894.09
Bottle Breakage		988.12	512.21
Total Manufacturing
Expense	4,204.25	6,373.08	5,635.62
Selling Expense:
Jobbers Brokerage	21.00
Sales Salaries	2,810.13	4,368.18	4,451.32
Sales Commissions	1,338.21	3,332.49	4,088.02
Traveling	24.88	96.08	263.31
Advertising	3,175.38	6,077.06	3,775.04
Advertising Shippers		678.64
Advertising Free Goods		4,076.54	2,424.24
Telephone and Telegraph	149.70	230.38	217.12
General Selling Expense			36.76
Total Selling Expense	7,519.30	2 18,859.97	15,255.81
Delivery Expense:
Gas, Oil and Grease	1,871.78	4,719.33	5,391.91
Truck Repairs	1,093.50	1,689.43	2,274.50
Truck Insurance	296.74	620.06	815.07
Truck Depreciation	1,184.57	2,661.29	2,858.11
Truck General Expense	206.47	453.89	611.59
Cases Repairs	23.57	370.56
Truck Hire	5.19
Truck Tires		1,048.59	1,555.49
Case Depreciation		573.18	738.92
Freight Out		625.04	477.98
General Delivery Expense			449.92
Total Delivery Expense	$ 4,681.82	12,761.37	15,173.49
Administration Expense:
Executive Salaries	1,228.27	1,860.78	1,076.43
Office Salaries	1,360.67	1,759.84	2,031.25
Stationery and Supplies	98.67	171.74	205.37
Postage	16.62	43.97	83.13
Legal	152.55	333.72	128.00
Dues and Subscriptions	45.25	7.00	45.50
Insurance	62.50	113.30	196.13
Furniture and Fixtures
Depreciation	77.44	122.10	126.13
General Administrative
Expense	142.73	445.49	33.70
Security and Excise Taxes	296.93	679.92	687.06
Cash Over and Short	2.68	.30	(132.37)
Taxes -- Other	92.50	176.75	356.25
Bottles and Cases Loss	919.26		673.86
Display Stands Depreciation	30.26	42.76	42.76
Bank Service Charge and
Exchange	5.82	33.82	50.94
Bad Debts			61.11
Total Administration
Expense	4,532.15	5,791.49	3 5,695.25
Total Expenses	24,038.16	49,408.64	47,240.94
Operating Profit	(802.95)	(1,841.57)	2,923.65
Other Income:
Profit on Sale of Truck and Car		56.25	131.32
Net Profit	(802.95)	(1,785.32)	3,054.97

Petitioner's income tax returns for the years 1940 and 1941 show a net loss of $ 814.61 for the year 1940 and a net profit of $ 3,554.01 for the year 1941.

The comparative balance sheet of petitioner for the years 1937 to 1939, inclusive, is as follows:

RAND BEVERAGE CO., INC.
Summarized Balance Sheets as Per Income Tax Returns as Filed
Assets:	12/31/37	12/31/38	12/31/39
Cash	$ 294.42	$ 354.24	$ 390.97
Notes and accounts receivable	1,631.15	6,355.07	10,447.68
Other investments -- U. S. Bonds
Inventories:
Raw material	1,253.26	4,010.92	4,447.59
Finished goods	374.88	717.24	1,016.92
Supplies, etc
Prepaid insurance, etc	339.11	428.86	407.73
Fixed assets:
Machinery	7,288.10	8,194.13	8,131.63
Furniture and fixtures	1,094.05	1,232.30	1,300.84
Delivery equipment	5,016.80	9,978.07	11,434.60
Cases & cartons	5,264.29	6,461.34	7,849.36
Leasehold	1,177.43	1,177.43	1,177.43
Coolers and other	332.12	268.91	637.92
Total	$ 20,172.79	$ 27,312.18	$ 30,531.78
Less: Reserve for depreciation, etc	[2,112.99]	[7,067.96]	[11,581.00]
Bottles (net)	12,713.50	22,582.38	27,560.11
Other assets	40.00	352.54	2,369.33
Accounts receivable -- officers
Post war refund due
Deposits
Total assets	$ 34,706.12	$ 55,045.47	$ 65,591.11
Liabilities and Capital:
Accounts payable	$ 10,245.07	$ 872.66
Notes & mortgages payable	24,372.67	53,338.06	61,168.21
Accrued expenses	57.41	251.55	272.18
Customers' deposits	533.92	2,192.83	3,384.02
Other liabilities		678.64
Common stock	300.00	300.00	300.00
Surplus	[802.95]	[2,588.27]	466.70
Total	$ 34,706.12	$ 55,045.47	$ 65,591.11

When petitioner started in business, it did not get deposits on bottles left with customers. In getting new customers, it was the practice for the truck driver who sold and delivered the drinks to the customers to make deliveries on consignment. The customer would pay petitioner for the drinks after they were sold. When the drivers made repeat calls, they would leave as many cases of drinks as the customer wanted and would pick up whatever empties the customer had on hand.

The amounts of $ 533.92, $ 2,192.83, and $ 3,384.02, appearing under "Customer Deposit" as a liability on the balance sheets for 1937, 1938, and 1939, represented the only money deposited on bottles during those years.

For the years 1937 to 1939, inclusive, the petitioner purchased 5,964-17/144 gross of bottles at a cost of 3.7 cents a bottle, or an aggregate of $ 31,779.96, including freight.

During the years 1937 to 1939, inclusive, the only charge on account of bottle loss taken by the petitioner was "Bottle Breakage" at the rate of one-half cent per case, which amounts were credited to the bottle account. There was no actual depreciation account for bottles on petitioner's books, the bottle breakage being charged off to manufacturing cost.

The bottle account, the amount charged to manufacturing cost and credited yearly as depreciation to the bottle account, and the depreciation reserve, as shown on petitioner's Federal tax returns, are as follows:

	Bottle		Depreciation
Year	account	Yearly credit	reserve
Dec. 31, 1937	$ 13,231.47	$ 517.97	1 $ 517.97
Dec. 31, 1938	24,088.47	988.12	1,506.09
Dec. 31, 1939	29,418.69	512.21	1,858.58
Dec. 31, 1940	33,062.95	547.09	2,405.67
Dec. 31, 1941	35,214.64	693.15	3.098.82
Dec. 31, 1942	9,161.00	20,747.11	0

As of December 31, 1939, petitioner's bottle account was carried on its books in the amount of $ 27,560.11, which amount was the net bottle account after deducting a depreciation charge of $ 1,858.58.

On its return for the year 1942, petitioner charged off bottle breakage and loss in the amount of $ 20,747.11 and bad debt loss in the amount of $ 15,665.04. In that year due to sugar rationing, petitioner was forced to abandon considerable territory and restrict its distribution of beverages. At that time, since the abandonment of much of the territory involved the loss of many unreturned bottles, an inventory of bottles was taken. No breakdown between the amount of bottle and case loss attributable to annual depreciation and the loss attributable to the contracting of territory under wartime conditions was made on the records of petitioner. The petitioner did not take an inventory of bottles in 1937, 1938, or 1939. Five per cent of total sales for case and bottle loss is a reasonable figure. Such figure, however, would not include losses from uncollectible accounts and would have no relation to such losses.

Petitioner's 1942 tax return contained an explanation with respect to the bad debt loss as follows:

This item represents approximately 3,200 different small accounts, covering deposits on cases and bottles mostly, which are uncollectible. During 1942 the credit policy was changed. Merchandise was sold for cash only and actual cash deposits for the cases and bottles were taken.

The bad debt amount of $ 15,665.04 was attributable, in large measure, to long-standing consignment charges that petitioner had not attempted to collect on a current basis, some of which proved to be uncollectible because certain customers had gone out of business or could not be located.

Petitioner did not know what part of the bottle loss and bad debt loss had actually occurred in 1942. The bad debt charge-off in 1942 represented 3.245 per cent of the total sales of $ 482,662.28 for the period 1937 to 1942, inclusive.

Notes and accounts receivable at the close of each of the years 1937 to 1942, inclusive, as shown by petitioner's tax returns, were as follows:

	12/31/37	12/31/38	12/31/39
Notes and accounts receivable	$ 1,631.15	$ 6,355.07	$ 10,447.68

	12/31/40	12/31/41	12/31/42
Notes and accounts receivable	$ 11,493.66	$ 9,005.01	$ 304.63

The amounts of $ 24,372.67, $ 53,338.06, and $ 61,168.21 shown on the balance sheets for the years 1937, 1938, and 1939, respectively, as notes and mortgages payable were those owed to the Economy Wholesale Grocery Co. and Roy F. Rand. No interest was shown on the profit and loss statements or the income tax returns for the years 1937, 1938, and 1939, as having been paid on such amounts during those years. Rand owned the grocery company and was president of the petitioner and its principal stockholder. The amounts of this outstanding indebtedness and the interest deduction claimed in petitioner's tax returns in the years 1940 to 1944, inclusive, are as follows:

	Mortgage	Interest
Date	payable	expense
Dec. 31, 1940	$ 68,970.67	0
Dec. 31, 1941	61,923.12	1 $ 115.56
Dec. 31, 1942	19,701.97	85.74
Dec. 31, 1943	1,000.00	11.93
Dec. 31, 1944	0	111.83

The record does not show that any other interest was owing by petitioner on such amounts.

Advertising expenditures in petitioner's industry are controlled by management and can be considered a fixed expense or a variable expense which fluctuates with sales in the discretion of management. Normally, however, as sales increase, advertising expenses also increase.

In July 1939 there were listed in the Little Rock telephone directory 10 different companies bottling soft drinks, and competition in Little Rock in the soft drink industry during the years 1937 to 1939, inclusive, was keen.

In 1935 the 7-Up Orange Crush Beverage Company of Little Rock began bottling 7-Up, a nationally advertised, one-flavor, carbonated beverage which was in competition with all other soft drinks. 7-Up production increased in 1936 over 1935 by more than 27 per cent, and increased in 1937 over 1936 by more than 27 per cent. 7-Up had an advantage over Rand's Better Beverages because the company producing 7-Up had been in business quite a few years with an established trade and a nationally advertised drink.

The Dr. Pepper Bottling Company in Little Rock manufactured a line of flavored drinks in 10-ounce bottles under the name of Moody's Made-Rite Bottled Beverages, and two franchised drinks, Dr. Pepper and NuGrape. This company had been operating since 1900 and commenced bottling Dr. Pepper in 1929, a nationally advertised drink in competition with all other carbonated beverages. It began bottling NuGrape in 1933. The company's production showed an increase in 1937 over 1936. The soft drink bottling business in Little Rock has shown an increase each year since 1933.

The production of soft drinks in cases by the Dr. Pepper Company for the years 1937 to 1939, inclusive, is as follows:

	1937	1938	1939
Dr. Pepper	58,754	64,574	65,301
NuGrape	9,083	18,954	29,454
Soda Water	76,236	72,097	70,842
Two Way	n1 3,772	(1)	(1)
Total cases	147,845	155,625	165,597

Flavors of soda water were Orange, Cream, Strawberry, and Root Beer. Sales of cases of carbonated drinks bottled by the Dr. Pepper Company showed an increase in 1939 over 1937 of 12 per cent.

The survey of cost averages for the years 1935 to 1939, inclusive, as prepared by the American Bottlers of Carbonated Beverages from 61 plants in 1935 to 198 plants in 1939 is as follows:

Table I. -- Cost averages -- 6 to 10 oz. (case of 24 bottles)
	Recommended comparatives (interquartile
	averages -- see note 1)
Cost item
	1935	1936	1937	1938	1939
	Cents	Cents	Cents	Cents	Cents
Material	24.6	26.8	26.7	24.9	25.7
Labor and overhead	09.9	09.0	09.3	10.8	09.2
Selling expense	06.2	07.2	08.5	08.7	10.1
Delivery expense	11.9	10.6	11.3	11.1	12.2
Administrative expense	08.7	09.4	08.2	07.8	07.3
Total cost (See Note 4)	62.7	62.4	63.7	64.8	62.1
Table II. -- Cost averages -- 12 to 16 oz. (case of 24 bottles)
	Recommended comparatives (interquartile
	averages -- see note 1)
Cost item
	1935	1936	1937	1938	1939
	Cents	Cents	Cents	Cents	Cents
Material	30.9	30.0	32.1	32.1	29.3
Labor and overhead	14.2	12.0	11.2	11.2	10.7
Selling expense	10.3	08.7	08.7	08.7	10.6
Delivery expense	15.5	13.1	12.6	12.6	13.2
Administrative expense	08.8	06.2	06.4	06.4	06.2
Total cost (See Note 4)	76.7	70.5	69.0	69.0	69.3
Table III. -- Cost averages -- 23 to 32 oz. (case of 12 bottles)
	Recommended comparatives (interquartile
	averages -- see note 1)
Cost item
	1935	1936	1937	1938	1939
	Cents	Cents	Cents	Cents	Cents
Material	28.6	28.7	28.7	25.5	28.2
Labor and overhead	19.0	13.3	12.2	13.6	12.2
Selling expense	14.3	07.7	09.0	08.1	09.5
Delivery expense	21.3	13.9	12.4	10.6	13.9
Administrative expense	09.3	06.5	06.6	06.3	06.2
Total cost (See Note 4)	97.8	70.4	69.0	68.5	69.3

NOTE 1: * * *

The figures representing unit costs for all plants reporting were arranged in order from the lowest cost to the highest cost reported in each classification of Cost Item. The first one-fourth of the figures shown in such arrangement (representing lowest costs) and the last one-fourth of such figures (representing highest costs) were then eliminated from consideration. The average of the individual plant costs appearing in the intermediate cost range (that is, between the lowest fourth and the highest fourth of the reports) was then determined, as the Inter-Quartile Average, and designated as the Recommended Comparative Average for the purposes of this survey.

With the elimination of the lowest fourth and the highest fourth of the reported figures, the midsection is generally accepted as the best basis for an average representing usual conditions. In this way the very low costs and very high costs due to inaccuracies in determining unit costs or to unusual conditions in the individual plant, are allowed to have no effect upon the determination of the averages.

* * * *

NOTE 4: The total cost shown in Tables I, II, and III, is the average of the Total Costs reported by individual plants. It is NOT the total of the other Cost Items shown in these Tables.

The aggregate of total average per case cost of all size bottles is as follows:

	1936	1937	1938	1939
	Cents	Cents	Cents	Cents
6 to 10 oz	62.4	63.7	64.8	62.1
12 to 16 oz	70.5	69.0	69.0	69.3
24 to 32 oz	70.4	69.0	68.5	69.3
Total	203.3	201.7	202.3	200.7

Statistics of business conditions in Arkansas and in the Little Rock area during the base period are as follows:

	Index of compiled
	receipts, all corporations	Index of retail
	State	sales, Little	Index of bank
	of Arkansas,	Rock, Ark.	clearances, Little
Year	"Statistics of Income,"	(Dun & Bradstreet -- two	Rock, Ark.,
	Treasury	reports	1939 as 100
	Department,	averaged),
	1939 as 100	1939 as 100
1936	98.3	81.5	80.3
1937	103.0	84.9	90.3
1938	92.7	82.7	85.1
1939	100.0	100.0	100.0

Statistics of sales of one competitor of petitioner in Little Rock for the years 1937 to 1939, inclusive, together with an index with 1939 as 100, are as follows:

	Sales in total	Index 1939 as
Year	cases	100
1937	147,845	89.3
1938	155,625	94.0
1939	165,597	100.0

Statistics of earnings and investments of 13 nonalcoholic beverage companies as compiled by the Securities and Exchange Commission showing sales, net profit before income taxes, net worth, and an index with 1939 = 100 compiled from those figures for the years 1936 to 1939, inclusive, are as follows:

Statistics on Earnings and Investment of Nonalcoholic Beverage Industry as Compiled by S. E. C. "Data on Profits and Operations 1936-1942" -- Part I, Page 199

			Net Profit
	Sales	Index 1939	Before
Year	(thousands)	as 100%	Income
			Taxes (thousands)
1936	$ 82,318	52.37	$ 29,053
1937	109,532	69.69	36,478
1938	119,625	76.11	37,873
1939	157,172	100.00	49,980

		Net Worth	Ratio of
Year	Index 1939	(thousands)	Income to
	as 100%		Net Worth
1936	58.13	$ 77,678	37.4
1937	72.98	83,138	44.0
1938	75.78	89,758	42.2
1939	100.00	106,192	47.1

Earnings of corporations engaged in the nonalcoholic beverage industry as shown by Statistics of Income, Part II, Treasury Department, and an index with 1939 = 100 compiled from those figures are as follows: ⁴

		Returns with net income
	Total
Year	number
	of returns	Number
		returns	Gross income	Net income
1936	1823	1106	$ 232,087	$ 56,024
1937	1912	1105	300,547	68,102
1938	1894	1038	245,645	39,557
1939	1960	1144	286,433	49,646

	Returns with no net income
Year	Number
	returns	Gross income	Net deficit
1936	656	$ 37,743	$ 2,332
1937	739	45,315	1,835
1938	808	42,301	2,326
1939	778	43,251	3,236

	1936	1937	1938	1939
Index of Net Income (1939 equals 100)	115.69	142.79	80.22	100.00

A national income index based on an average for the years 1936-1939 = 100 from the Survey of Current Business, U. S. Department of Commerce, July 1950, Table 4, page 10, reduced to 100 for 1939 is as follows:

	National
Year	income index	Reduced to
	1936 - 1939 = 100	100 for 1939
1936	93.0	89.1
1937	105.8	101.3
1938	96.8	92.7
1939	104.4	100.0

A corporate profits index for the years 1936-1939, based on the years 1922-1939=100, from Internal Revenue Bulletin 1945, page 274, Table I, Column 5, reduced to 100 for 1939 is as follows:

	Corporate	Reduced to
Year	profits index	100 for 1939
1936	127.3	97.0
1937	128.3	97.7
1938	46.8	35.6
1939	131.3	100.0

Petitioner's excess profits tax for the calendar years 1943, 1944, and 1945 computed without the benefit of section 722 resulted in an excessive and discriminatory tax.

Petitioner's average base period net income is an inadequate standard of normal earnings. Such net income does not reflect the normal operation for the entire base period, nor does it reflect the earning level which petitioner would have obtained if it had commenced business two years before it did.

Petitioner's constructive average base period net income to be used in computing its excess profits credit for the years 1943, 1944, and 1945 is $ 5,700.

OPINION.

In its application for relief and in its petition, petitioner claimed relief under section 722 (b) (5) but did not press such claim in its brief. Since the facts of record do not indicate that any relief under subsection (b) (5) is warranted, relief under such provision is denied. Del Mar Turf Club, 16 T. C. 749 (1951).

This leaves for our consideration (1) whether peitioner qualifies for relief under subsection (b) (4); (2) whether it is entitled to use the "2-year push-back rule"; and (3) if (1) and (2) are answered in the affirmative, what is a fair and just amount representing normal earnings of the petitioner to be used as a constructive average base period net income.

Petitioner commenced business in April 1937 and therefore has one of the qualifying factors required by section 722 (b) (4). ⁵ We have found as a fact that petitioner's average base period net income is an inadequate standard of normal earnings. Petitioner also claims that the change from the promotion of a nationally franchised drink to a drink developed by petitioner and bearing its own brand name constituted a difference in the products furnished under section 722 (b) (4). Respondent denies that such change was a change in the character of the business within the meaning of the statute. Whether or not it constituted a change in the character of the business need not be decided in this case because it is an alternative qualifying provision under the statute; and since petitioner meets the other qualifying factor, commencement of business in the base period, it is not necessary for it to meet the alternative qualifying factor also. This is not to say, however, that production and sale of the new-drink line are not to be considered in a reconstruction of average base period net income.

Petitioner's excess profits credit was computed on the invested capital method and resulted in credits in the following amounts:

1943	$ 963.27
1944	1,577.23
1945	2,755.17

Petitioner's net profits and net losses for the years 1937 through 1939 were as follows:

1937	$ 802.95 loss
1938	1,785.32 loss
1939	3,054.97 profit

If the business of a taxpayer does not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business 2 years before it did so, it is deemed to have commenced the business at such earlier time. Sec. 722 (b) (4), supra.

Petitioner's formative years followed the pattern of the industry of which it is a member. Two of petitioner's witnesses were engaged in the production of carbonated beverages in the Little Rock area in competition with petitioner. One of the witnesses was the manager and a partner of the 7-Up Orange Crush Beverage Company and had been engaged in the business since 1926. The other witness was the president and manager of the Dr. Pepper Bottling Company and had been in the business for 20 years. The testimony of said witnesses was to the effect that a normal development period for a new company similar to petitioner would be not less than 4 years and probably more. They both testified that the volume of increase in sales claimed in petitioner's reconstruction was reasonable in their opinion, and less than they had experienced under similar circumstances. We have found as a fact that petitioner had a normal development period of between four and five years, and that it did not reach by the end of the base period the earning level that would have been reached if the business had commenced in 1935 instead of 1937; and we, therefore, conclude that petitioner qualifies for relief under section 722 (b) (4) and is entitled to use "the 2-year push-back rule" in reconstructing its average base period net income.

Respondent argues that petitioner's failure to qualify for relief is shown, in part at least, by the fact that it sustained a net loss of $ 814.61 in 1940, and realized a net profit of only $ 3,554.01 in 1941. Assuming that these facts may be considered, we do not agree that they disqualify petitioner from relief under subsection (b) (4). Petitioner's development period, as pointed out above, was between four and five years; and its fifth year of existence -- 1941 -- saw it continuing to experience some development difficulties. The loss in 1940 and the comparatively small net profit in 1941 tend to corroborate our conclusion that petitioner had not reached its normal earning level during its last base period year.

We then come to our final question -- "What is a fair and just amount representing normal earnings of the petitioner during the base period?" Both parties submitted reconstructions of average base period net income using the "2-year push-back rule." Petitioner's reconstruction arrived at an average figure of $ 10,170.49. Respondent's reconstruction showed a net loss of $ 10,211.78 for the last base period year. The main or basic differences between the two reconstructions related to the reconstruction of sales and the different treatment accorded certain bottle losses, interest expense, and bad debts. Petitioner reconstructed a sales volume for 1939 in the amount of $ 96,852.10. Respondent allowed the sum of $ 80,000. The figures used for cost of materials, factory labor, overhead, selling, delivery, and administrative expenses did not vary greatly in either reconstruction. Respondent added the following deductions as expenses:

Additional bottle-loss depreciation	$ 8,405.55
Interest expenses	3,434.98
Bad debts	2,596.00
Total	$ 14,436.53

Petitioner's reconstruction allowed no deduction for interest and allowed $ 4,842.60 as a deduction for bottle and case loss and for bad debts. This figure is 5 per cent of reconstructed gross sales.

Petitioner's reconstruction of expenses, other than the three just mentioned, was somewhat lower than the survey of cost averages prepared by the American Bottlers of Carbonated Beverages set out in our findings of fact; and although one of petitioner's expert witnesses testified that such cost averages for the base period years were a reliable index of costs in the carbonated beverage industry, such indices are national in scope and do not necessarily reflect to the last penny the costs of many local businesses in the industry.

With respect to bottle and case loss, both of petitioner's expert witnesses testified that 5 per cent of sales was a reasonable figure for such loss, which is about three and one-half cents a case. With respect to the bad debt loss, it must be remembered that petitioner was attempting to break into a highly competitive business. The only market available for the petitioner's products (other than the franchised drink on which it claims no reconstructed increases in sales) was dependent upon its ability to capture a portion of the demand that was already being supplied by other members of the industry. Because of this intense competition, petitioner during the base period years sold its beverages on a consignment basis. Petitioner's competitors were on a strictly cash basis with their customers, and required them to make a deposit on all cases of drinks left with them. Petitioner did not require a deposit from its customers, and it did not charge off any uncollectible amounts during the base period years arising out of such consignment practice.

In 1942, petitioner wrote off bad dabts in the amount of $ 15,665.04 with the explanation in its income tax return that it represented approximately 3,200 different small accounts which were uncollectible. It also changed its credit policy at that time, selling its merchandise for cash only, and requiring cash deposits on its cases and bottles in conformity with the practices of its competitors.

The record shows that the normal practice in petitioner's industry was to sell its product on a cash basis rather than on a consignment basis; but it also shows that it was normal practice for petitioner to sell on the consignment basis. In seeking normality in a reconstruction, it is appropriate to give consideration and effect to any special circumstances peculiar to the specific taxpayer where such circumstances are normal for such taxpayer even though they might not be normal for another taxpayer engaged in the same business.

Our last item of expense is interest. Petitioner was indebted to Roy F. Rand and the Economy Wholesale Grocery (owned by Rand) in the amounts of $ 24,372.67, $ 53,338.06, and $ 61,168.21 for the years 1937, 1938, and 1939, respectively. No deduction for interest on this indebtedness was claimed on petitioner's tax returns for those years. The respondent claims that interest on borrowed money is a normal business expense, and included in his reconstruction for petitioner's last base period year an amount of 6 per cent of the indebtedness as an additional expense. Petitioner argues that no interest (or, at most, a nominal amount) was owed on this indebtedness, and that interest which does not exist in fact is not a proper item to be considered in a reconstruction of normal earnings. While, generally speaking, interest is an ordinary and normal expense of business, it is not unusual or abnormal for the chief stockholder of a corporation to lend money to it in its formative years, or when it gets in financial difficulties, without requiring interest payments on such loans.

As shown in our findings of fact, petitioner used an index from statistics of nonalcoholic beverages, published in the Treasury Department's "Statistics of Income." Respondent argues that this is not a proper index for such purpose because of a reclassification in 1938 resulting in statistics for 1936 and 1937 not being comparable with those for 1938 and 1939. In support of this argument, he cites Treasury Department's "Statistics of Income for 1938, Part 2," pp. 256 and 266, which shows that in adopting a standard Industry Classification in 1938, reports of manufacturers of cider and mineral or spring water, classified in 1936 and 1937 under nonalcoholic beverages, were shifted to "Other Food, Including Flavoring Sirups," while mineral and spring-water bottling was shifted to "Wholesale Trade." We agree with respondent that use of such index is not warranted by this record when compared with the other indices set out in our findings of fact.

Petitioner argues that the official compilation in "Statistics of Income" for all income tax returns filed by all manufacturers of nonalcoholic beverages shows a national, average net income of 14.1 per cent of sales for the year 1939, and a base period, average net profit of 16.4 per cent of sales. It also points to the testimony of the two expert witnesses, one of whom testified that a net profit before taxes of 8 cents to 15 cents a case, was normal during the base period; and the testimony of the other witness who said that a range of 10 cents to 15 cents a case was normal. In petitioner's reconstruction he claimed a net profit of 9.57 per cent of sales which amounts to 6.7 cents a case.

We, therefore, conclude, based upon the entire record of this case, that petitioner is entitled to use a reconstructed average base period net income in the sum of $ 5,700. In arriving at such amount, we have considered carefully all the facts of record including the bottle loss, bad debt loss, and interest, and have accorded to each of the items the treatment we consider appropriate.

Reviewed by the Special Division.

Decision will be entered under Rule 50.

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Footnotes

• 1. A franchised drink is one that is advertised and sold on a national scale and the flavoring extract for which is purchased from the national manufacturer.↩

• 2. Actually adds $ 18,859.37.↩

• 3. Actually adds $ 5,665.25.↩

• 1. This amount used to reduce asset amount on balance sheet attached to return.↩

• 1. Interest and exchange.↩

• 1. Put into Soda Water.↩

• 4. Amounts reported in thousands of dollars, before income taxes.↩

• 5. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.

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  (b) Taxpayers Using Average Earnings Method. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because --

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  (4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the purposes of this subparagraph, the term "change in the character of the business" includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, a difference in the ratio of nonborrowed capital to total capital, and the acquisition before January 1, 1940, of all or part of the assets of a competitor, with the result that the competition of such competitor was eliminated or diminished. Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, or

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