*43 Decision will be entered under Rule 50.
Claims for relief under section 722 (b) (4) allowed where there was a change in the character of petitioner's business during or immediately prior to the base period, and to the extent that the manufacturing costs would have been reduced with 2 years' additional experience.
*242 This proceeding involves claims for relief under section 722 (b) (4) of the Internal Revenue Code of 1939. It is petitioner's contention that it changed the character of its business during or immediately prior to its base period when it began the manufacture and sale of a new type of bearing for steel mill rolls. The testimony was taken by a commissioner of this Court. Some of the*44 facts have been stipulated and are incorporated in our Findings of Fact and are found accordingly.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the Commonwealth of Massachusetts in 1891. Its office and principal place of business are located at Worcester, Massachusetts. Petitioner's principal business consists of the manufacture and construction of rolling mills and the manufacture of wiremaking machinery, gas producers, combustion controls, and a special type of bearing used in rolling mills known as Morgoil.
Continuous steel rolling mills were developed in England about 1860. They were introduced to the steel industry in America by petitioner's founder, Charles Morgan, about 1888.
The rolling mill performs the first step in converting the output of the steel mill into finished products. The ingots, as they come from the rolls, are first rolled into "blooms" and then further rolled, in mills such as petitioner constructs, into different shapes and sizes adaptable to the various products to be manufactured.
Petitioner manufactures billet mills, rod mills, merchant mills, skelp mills, and narrow strip mills. It does not manufacture the large plate*45 mills.
Prior to 1925 and 1926, open or "pad" type bearings were used in rolling mills. This bearing was an open top iron or steel casting fitted with a bronze shoe and lined with babbitt, or some other bearing *243 metal, which supported the roller spindle. They were hand lubricated and were not capable of high-speed operation or accurate adjustment.
The steel rollers are commonly referred to in the industry as "rolls" and the spindles as "roll necks." The unit supporting the rolls is referred to as a "stand" and is further described as a "2-hi stand" or "4-hi stand" according to the number of rolls it contains. The rolls vary in size from a few inches to over 4 feet in diameter. Some of them operate at very high speeds of more than 60 miles per hour and under pressure as great, in some instances, as 4 million pounds. In the rolling process the metal bar is passed back and forth between the rolls which gradually press it into the desired shape.
With the progress of the steel industry and the improvement in rolling mills, particularly the continuous, high-speed type, it became necessary to develop a bearing capable of greater speed and more efficient operation than the old*46 pad type bearing. Roller bearings, such as the Timken, were first tried, and met with some success, but they were not entirely satisfactory.
Prior to 1930, the petitioner, in collaboration with the Timken Roller Bearing Company, conducted experiments in an effort to perfect a roller bearing which would operate satisfactorily, but these experiments were not entirely successful. However, they did lead to the development by one of petitioner's engineers, about 1931, of a sleeve type roll neck bearing, fully enclosed and flood lubricated, of high load capacity and low frictional characteristics, which gave promise of solving the bearing defects. A patent on the bearing was applied for in the United States in August 1931, and in Great Britain in August 1932. This bearing was introduced to the trade as the Morgoil bearing, in 1932.
The first commercial installation of Morgoil bearings was made in January 1932 at the Sharon Steel Company mill at Sharon, Pennsylvania. They were small bearings installed in a 2-hi roughing stand with 8-inch rolls. They proved satisfactory for that type of operation, although many changes were later required in design and in the composition of the metals*47 used in different parts of the bearing.
During 1932 and 1933, petitioner installed Morgoil bearings in other plants, including those of Youngstown Sheet and Tube Company, American Rolling Mills Company, United Steel Company, Ltd., of England, and Ford Motor Company.
A few of the larger type bearings were installed, experimentally, prior to 1935 but the first sale of the large bearings was in that year. The 4-hi stand contains two small working rolls which make contact with the metal and two much larger rolls, referred to as "back-up" rolls, which operate directly against the small rolls to support the enormous pressure exerted against them. It was in these heavy-duty, *244 high-speed installations that trouble developed with the Morgoil bearings, after a period of usage. The soft babbitt linings first used had to be replaced by a harder metal; the design of the thrust bearing, the function of which was to take up the end-to-end pressure on the rolls, had to be redesigned; and changes were required in the lubricating system. Although these early installations did not prove entirely satisfactory, they did establish the soundness of the principles of the Morgoil bearing and *48 assured its ultimate success.
The following table shows the total number of Morgoil bearings booked, or ordered, during the years 1932 to 1941, inclusive, broken down as to domestic and foreign mills, and also as to the bearings which were to be installed in complete mills to be constructed by petitioner:
| Morgoil Bearings Booked | ||||||||
| For other customers | ||||||||
| For use on complete | ||||||||
| Morgan Mills | ||||||||
| Year | 22 inches and under | Over 22 inches | ||||||
| Domestic | Foreign | Total | Domestic | Foreign | Domestic | Foreign | Total | |
| 1932 | 28 | 36 | 64 | 2 | 2 | |||
| 1933 | 56 | 56 | 4 | 14 | 18 | |||
| 1934 | 8 | 252 | 260 | 10 | 10 | |||
| 1935 | 60 | 60 | 52 | 97 | 4 | 153 | ||
| 1936 | 228 | 476 | 704 | 192 | 4 | 193 | 8 | 397 |
| 1937 | 4 | 284 | 288 | 96 | 8 | 145 | 46 | 295 |
| 1938 | 24 | 104 | 128 | 36 | 24 | 112 | 24 | 196 |
| 1939 | 4 | 4 | 8 | 48 | 8 | 145 | 10 | 211 |
| 1940 | 127 | 8 | 135 | 32 | 204 | 4 | 240 | |
| 1941 | 100 | 148 | 248 | 112 | 4 | 168 | 284 |
The 1936 orders included one for 172 bearings from Amtorg, the Russian Purchasing Commission; another for the same number of bearings from the Bethlehem Steel plant at Sparrows Point; one for 100 bearings from United Engineering and Foundry Company; and one for 40 bearings from E. W. Bliss*49 and Company.
From about the beginning of 1936 there was a rapid development in the industry in the production of large sheet steel and other metals for use in the manufacture of automobiles, airplanes, and other uses, which required the installation of a large number of 4-hi stand mills. Most of petitioner's domestic orders, after 1936, were for bearings for rolls over 22 inches in diameter, as shown in the above table.
One of the chief difficulties that developed in the Morgoil bearing was "scuffing" of the bearing sleeve, resulting in damage to the roll necks. The large roll necks at that time were cylindrical rather than tapered, as were the necks of the small rolls for which the Morgoil bearing was first designed. To meet this difficulty, petitioner developed a new method for keying the bearing sleeve to the cylindrical *245 roll neck. Also, early in 1936, the roll manufacturers began tapering the necks of the large rolls as well as the small rolls. Petitioner also developed a new, harder type of bearing metal and a new method of applying it centrifugally to the bearing surface. In 1939 an important change was made in the thrust bearing which required a longer roll *50 neck than was then in use. At its own expense, petitioner undertook to extend the necks of the rolls in a large number of mills where its bearings had been installed. Alterations were made on about 180 of the large rolls.
News of the difficulties which had developed in the Morgoil bearings spread quickly throughout the industry, to the detriment of petitioner's reputation and, to some extent, the promotion of Morgoil bearings.
From time to time in the course of development of the Morgoil bearing, petitioner acquired tools and equipment necessary for its production. The following such equipment was acquired during the years 1933 to 1937, inclusive:
| Purchase of Equipment for Manufacture of Morgoil Bearings | |||
| 1931 | None | ||
| 1932 | None | ||
| 1933 | Order 87975 | Alteration to vertical boring mill #289, | |
| providing grinding equipment for | |||
| Morgoil bearings | $ 2,003.12 | ||
| Order 89001 | Babbitt pot | 529.88 | |
| 1934 | Order 87976 | 3 -- Steel cleaning pots for Morgoil | |
| bearing bushings | 238.27 | ||
| 1935 | Order 87978 | Cleaning, tinning and centrifugal casting | |
| units for handling large size | |||
| Morgoil bearings | 13,837.08 | ||
| Order 89027 | Electric cadmium melting furnace | 18.00 | |
| Order 87977 | Further alteration to boring mill #289 | ||
| for use in grinding Morgoil bearing | |||
| sleeves | 4,959.12 | ||
| 1936 | Order 89056 | 1 -- King 72" heavy duty vertical | |
| boring mill | 96.00 | ||
| Order 89060 | 1 -- Bullard 36" vertical turret lathe | 244.50 | |
| Order 87978 | Cleaning, tinning and centrifugal casting | ||
| equipment for large Morgoil bearings | 15,101.66 | ||
| Order 89027 | Electric cadmium melting furnace, 32kw | 3,949.89 | |
| Orders 87980 and | Equipment for internal grinding on | 1,555.83 | |
| 87981 | machine 289 | and 3,839.99 | |
| Order 89019 | 1 -- Norton 20" x 144" Type D grinding | ||
| machine | 16,543.91 | ||
| Order 89020 | 1 -- King 72" heavy duty vertical | ||
| boring mill | 19,598.24 | ||
| Order 89025 | 1 -- Bullard 54" vertical turret lathe | 14,265.73 | |
| Order 89030 | 1 -- Bullard 42" vertical turret lathe | 11,101.89 | |
| Order 89031 | 1 -- Bullard 36" vertical turret lathe | 10,236.59 | |
| Order 89032 | 1 -- Norton 14" x 72" grinding machine | 10,620.46 | |
| 1937 | Order 89089 | 1 -- #28B Hydroil internal grinder | 8,912.99 |
| Order 89090 | 1 -- #52 Hydroil grinder | 2,473.00 | |
| Order 89056 | 1 -- King 72" vertical boring mill | 26,116.36 | |
| Order 89058 | 1 -- Norton cylindrical grinder | 29,622.44 | |
| Order 89060 | 1 -- Bullard 36" vertical turret lathe | 9,674.43 | |
| Order 87983 | 1 -- Centrifugal casting machine | 3,386.91 |
*51 The manufacture of the Morgoil bearings requires a high degree of engineering and mechanical skill. The design of the bearing is complicated and the many working parts must be tooled and fitted *246 with great precision. The larger bearings sometimes weigh as much as 40,000 pounds. The cost of the bearings, during the base period, ranged from about $ 3,000 to over $ 40,000 a set.
As indicated above, petitioner sold and installed Morgoil bearings in plants already in operation which had been constructed by others, as well as in the plants which it designed and built. Every such installation presented an engineering problem inherent in adapting the bearings to the particular type of operation being conducted. The requirements of the large roll, high-speed mills were much more exacting than those of the smaller roll, low-speed mills.
The following tables show the dollar sales on orders for Morgoil bearings closed during the years 1932 to 1943, inclusive, the cost of such bearings, and the unadjusted gross profits thereon, both as to bearings for installation in mills already in operation and as adjusted for the estimated contract price of bearings for mills to be constructed*52 by petitioner, the cost of which was included in the contract price for the completed mill:
| Year | Selling price | Cost | Profit |
| 1932 | $ 655.71 | $ 6,785.78 | $ 69.93 |
| 1933 | 62,134.39 | 51,533.88 | 10,600.51 |
| 1934 | 134,548.03 | 117,466.78 | 17,081.25 |
| 1935 | 79,171.71 | 71,327.15 | 7,844.56 |
| 1936 | 626,709.16 | 541,801.19 | 84,907.97 |
| 1937 | 531,235.99 | 485,022.13 | 46,213.86 |
| 1938 | 1,597,058.01 | 1,304,697.15 | 292,360.86 |
| 1939 | 816,576.04 | 630,485.92 | 186,090.12 |
| 1940 | 786,857.86 | 588,640.22 | 198,217.64 |
| 1941 | 1,208,488.47 | 821,040.52 | 387,447.95 |
| 1942 | 1,032,162.71 | 701,715.21 | 330,447.50 |
| 1943 | 691,654.70 | 505,701.52 | 185,953.18 |
| Above Figures Adjusted to Include Bearings Sold as Part of Mill Contracts | |||
| Selling price | Cost | Profit | |
| 1932 | $ 6,855.71 | $ 6,785.78 | $ 69.93 |
| 1933 | 62,134.39 | 51,533.88 | 10,600.51 |
| 1934 | 134,548.03 | 117,466.78 | 17,081.25 |
| 1935 | 190,699.71 | 142,945.33 | 47,754.38 |
| 1936 | 660,459.16 | 568,887.96 | 91,571.20 |
| 1937 | 595,235.99 | 549,145.80 | 46,090.19 |
| 1938 | 1,842,113.01 | 1,503,397.84 | 338,715.17 |
| 1939 | 855,976.04 | 664,672.31 | 190,703.73 |
| 1940 | 997,287.86 | 757,049.47 | 240,238.39 |
| 1941 | 1,216,199.47 | 825,979.54 | 390,219.93 |
| 1942 | 1,032,162.71 | 701,715.21 | 330,447.50 |
| 1943 | 790,320.70 | 586,972.17 | 203,348.53 |
*53 The following table shows the number and types of rolling mills construction in the United States over the period of 1935 to 1939, inclusive, or in process of construction at December 31, 1939: *247
| 1939 | ||||||
| Type mills | 1935 | 1936 | 1937 | 1938 | In process of | |
| Completed | construction, | |||||
| December 31 | ||||||
| Band | 1 | |||||
| Bar | 1 | |||||
| Beam | 2 | |||||
| Billet | 1 | |||||
| Blooming | 2 | 2 | 3 | 2 | 2 | |
| Breakdown | 6 | 3 | 1 | 1 | ||
| Broadside | 1 | |||||
| Buttweld | 1 | 1 | 7 | |||
| Cold mill | 1 | |||||
| Cold sizing | 1 | |||||
| Edging | 1 | 1 | 1 | 2 | 1 | |
| Merchant | 1 | 3 | 1 | |||
| Reversing | 1 | |||||
| Rod | 2 | 3 | ||||
| Sheet | 1 | 9 | 7 | |||
| Sheet bar | 1 | |||||
| Skir pass | 2 | 5 | 3 | |||
| Slabbing | 1 | 1 | ||||
| Strip | 30 | 31 | 28 | 29 | 9 | 4 |
| Stainless | 3 | |||||
| Structural | 8 | |||||
| Tin | 7 | 10 | ||||
| Tube | 2 | |||||
| Tube piercing | 2 | |||||
| Tube reducing | 1 | |||||
| Totals | 39 | 51 | 57 | 50 | 36 | 17 |
Petitioner constructed one of such domestic mills in 1935, one in 1936, and one in 1939. It also constructed four foreign mills in 1936, one in 1937, and one in 1938.
Petitioner's sales for 1932 to 1941, inclusive, of rolling mills and Morgoil bearings and its total sales for all departments, including wire department, *54 gas producer department, combustion control department, and "miscellaneous," were as follows:
| Morgoil | Total sales all | ||
| Year | Rolling mill | bearings | departments |
| 1932 | $ 337,196.36 | $ 472,147.49 | |
| 1933 | 305,483.57 | $ 71,338.39 | 487,025.18 |
| 1934 | 451,726.67 | 116,020.03 | 736,884.39 |
| 1935 | 1,089,348.03 | 120,995.13 | 1,337,631.56 |
| 1936 | 816,047.32 | 667,160.76 | 1,825,157.32 |
| 1937 | 2,857,597.39 | 1,298,745.89 | 4,767,619.59 |
| 1938 | 946,429.65 | 860,569.76 | 2,041,444.03 |
| 1939 | 1,754,562.80 | 785,814.02 | 2,956,964.66 |
| 1940 | 933,332.31 | 818,021.09 | 2,367,092.77 |
| 1941 | 1,924,452.28 | 1,373,939.96 | 4,484,057.04 |
Petitioner's net profits and losses, before taxes, from its entire operations for the years 1920 to 1939, inclusive, were as follows:
| 1920 | $ 292,130 |
| 1921 | 60,539 |
| 1922 | 203,932 |
| 1923 | 364,261 |
| 1924 | 304,343 |
| 1925 | 623,733 |
| 1926 | 939,345 |
| 1927 | 717,212 |
| 1928 | 483,522 |
| 1929 | 609,092 |
| 1930 | $ 312,802 |
| 1931 | (489,290) |
| 1932 | (358,653) |
| 1933 | (260,159) |
| 1934 | (149,784) |
| 1935 | 86,381 |
| 1936 | 197,142 |
| 1937 | 495,393 |
| 1938 | 239,403 |
| 1939 | 273,819 |
*248 Petitioner was not utilizing its full capacity for the production of Morgoil bearings at the close of 1939. It made bids on a number *55 of jobs in 1939 which it failed to obtain.
In accordance with a long established practice, petitioner paid into an employees' bonus fund each year 50 per cent of its gross profits, less:
1 -- 6% of Surplus account and of Common Capital, both as of 31st Dec. of the previous year,
2 -- Accrued dividends on preferred stock, if any, all as outlined in memorandum "Method of Figuring Bonus", dated 30 January 1930,
* * * *
Pursuant to this plan, bonuses were paid to petitioner's employees amounting to $ 90,821.77 in 1936; $ 326,153.07 in 1937; $ 112,209.49 in 1938; and $ 151,394.36 in 1939.
The long period spent in the development of the Morgoil bearing and the large number of adjustments and replacements which petitioner was required to make in its early installations resulted in a proportional increase in operating expenses during the base period.
Petitioner is entitled to excess profits credits based on income. For all years involved, petitioner's excess profits credits based on income are in excess of its credits based on invested capital.
For its base period years, 1936 to 1939, inclusive, petitioner's excess profits net income, and its average base period net income, were as follows: *56
| Excess profits | |
| Year | net income |
| 1936 | $ 197,175.79 |
| 1937 | 464,835.70 |
| 1938 | 241,512.07 |
| 1939 | 268,928.42 |
| Total | $ 1,172,451.98 |
| Average base period net income | $ 293,113.00 |
| Excess profits credit (95 per cent) | $ 278,457.35 |
For 1942 and subsequent years, petitioner's excess profits credit was $ 289,535.12.
Petitioner's excess profits net income and excess profits tax liability for the taxable years 1941 to 1945, inclusive, were as follows:
| Excess profits | Excess profits | |
| Year | net income | tax liability |
| 1941 | $ 843,556.15 | $ 288,334.84 |
| 1942 | 499,533.48 | 184,498.52 |
| 1943 | 356,680.25 | 55,930.62 |
| 1944 | 409,613.01 | 94,116.60 |
| 1945 | 463,565.06 | 140,245.60 |
*249 Claims for refund of excess profits taxes under section 722 were timely filed by petitioner for each of the years 1941 to 1945, inclusive. Petitioner alleged in such claims that it was entitled to relief under the provisions of subsections (b) (2), (b) (3), (b) (4), and (b) (5). In these applications the petitioner claimed relief, in part, on the invention and development of the Morgoil bearing. Petitioner claimed that:
In considering the normal earnings of this company, and in considering the base period*57 earnings of this company, it must not be overlooked that in 1933 the company put on the market a new product known as "Morgoil". The normal earnings of the company from that time forward would have to include not only the expected normal earnings as they were before that time, but also the normal earnings of "Morgoil" so that, for the base period, it would be necessary to add to Morgan's theretofore normal income the normal income from "Morgoil" and this is a considerable figure, certainly not less than $ 100,000 a year. For Morgoil's sales which start at $ 71,338 in 1933 were $ 667,161 in 1936, $ 1,298,749 in 1937, $ 867,570 in 1938, and $ 785,814 in 1939. Normal average annual sales of "Morgoil" would be about a million dollars and normal average profit would be around 11 or 12%. No comparison of the base period years with other years prior to the base period should be made without deducting Morgoil's sales or profits and no constructive base period income could fairly be made without taking into account the normal expected profits of the company from its long established business plus the normal expected profits of "Morgoil".
The petitioner also stated in its claim that:
*58 the manufacture and sale of Morgoil which got under way successfully about 1936, constituted a new and different business for Morgan. Under the rules of common sense and even under the Bulletin, the profits of Morgoil should be segregated from the profits of Morgan in order to determine a constructive net income, because in the base period Morgan was entitled to a normal earnings on its regular business, plus the earning [sic] on Morgoil, a new business.
Morgan's total sales in 1936 were $ 1,496,282, of which $ 667,161 were Morgoil;
Morgan's 1937 sales were $ 4,159,220, of which $ 1,298,746 were Morgoil;
Morgan's 1938 sales were $ 1,818,840, of which $ 860,570 were Morgoil;
Morgan's 1939 sales were $ 2,587,205, of which $ 785,814 were Morgoil.
Morgoil constituted 35.9% of Morgan's base period business, and the profits on Morgoil were far in excess of 12%. Morgan's $ 313,000 actual base period income included not less than $ 108,350 income for Morgoil, and Morgan's reconstructed base period income of $ 461,258 should be increased by $ 108,350, representing Morgoil.
All the above claims were considered by the respondent. The report*59 of the revenue agent assigned to investigate the petitioner's claims for relief, dated December 23, 1947, states as follows:
(b) (4) In the statements attached to its applications for the years 1941 to 1945 inclusive, taxpayer claims that it changed the character of its business in that it had a change in its products just prior to and during the base period, such as would entitle it to relief. Taxpayer says the manufacturing of the old style *250 wire drawing machines was discontinued just prior to the base-period years and a new different, far better type of wire drawing machine was perfected and produced and sold by Morgan. It also says that a marvelous new bearing called Morgoil was invented by its engineers and put on the market during the base period. In the memorandum filed August 28, 1946, taxpayer says, about 1933 the Morgan Construction Company invented a remarkable new type bearing known as Morgoil, and the manufacture and sale of Morgoil which got underway successfully about 1936, constituted a new and different business for Morgan.
* * * *
The Morgoil average for the base period earnings were determined to be $ 108,350.00 and were arrived at by applying the *60 estimated percentage of profit on Morgoil sales of 12 percent to the actual Morgoil sales during the years 1936-1939 inclusive.
* * * *
In its original applications for relief, covering the years 1941 to 1945, inclusive, taxpayer asserts that a new bearing called "Morgoil" was invented by its engineers and put on the market during the base period. In the additional data dated November 18, 1944, and submitted by taxpayer, it said, it must not be overlooked that in 1933 the company put on the market a new product known as "Morgoil." While in the memorandum submitted by the taxpayer and received on August 28, 1946, it was stated about 1933, Morgan Construction Company invented as we have heretofore shown, a remarkable new type bearing known as Morgaoil [sic] and the manufacture and sale of Morgoil which got underway successfully about 1936, constituted a new and different business for Morgan. It claims that this constitutes a change in produce [sic] such as would entitle it to relief.
The commencement or change in character of a business will be considered to have occured [sic] immediately prior to the base period if under normal conditions, the earning level of the business*61 so commenced or changed would not be realized until sometime during the base period and would be directly related to the commencement or change. However, if the period of initial development ordinarily required by a business to perfect its internal operations and establish its position in the industry had been completed by the beginning of the base period, the commencement or change in character will not be considered to have occured [sic] immediately prior to the base period.
A patent for the Morgoil bearing was applied for on August 7, 1931, it was issued October 22, 1935. The bearing was introduced to the trade in 1932, according to articles on same in the March 21, 1932 issue of "Steel", and the June 1936 issue of "Metal Industry." The article in "Steel" described the new bearing. The article in "Metal Industry", written by J. H. Hitchcock of Morgan Construction Company, also described the bearing and says that Morgan developed a few years ago, an oil lubricated sleave [sic] bearing, that after several years of thorough investigation, this bearing was introduced to the trade in 1932, as the "Morgoil" bearing. Mr. Hitchcock in his article further says that more than*62 half of the six hundred old Morgoil bearings now in operation are installed in existing mills, where they have replaced either roller bearings or the conventional opern [sic] type bronze and babbit [sic] or non-metallic bearings. Morgoil bearings are constructed for rolls varying from 8" to 56", they have been installed in both hot and cold two high, three high, and four high rolling mills and are also being used in the non-ferrous field, according to Mr. Hitchcock's article.
The first order for a Morgoil bearing was taken by taxpayer on January 25, 1932. It was also the first installation.
*251 The following information with reference to taxpayers sales of Morgoil bearings was obtained from its records.
| United | ||
| Sales | ||
| Morgoil | ||
| Year | Bearings | Amount |
| 1932 | 50 | See Below |
| 1933 | 74 | $ 71338 |
| 1934 | 270 | 116020 |
| 1935 | 213 | 120995 |
| 1936 | 1,133 | 667161 |
| 1937 | 555 | 1298746 |
| 1938 | 320 | 860570 |
| 1939 | 219 | 785814 |
The 1932 dollar sales are not kept separately, but are included in the rolling mill sales. The increased dollar sales with the lesser unit sales is accounted for by the greater selling price for the larger bearings, sold.
It is evident that no period of initial*63 development fell within the base period. The change in character of taxpayer's business took place in the year 1932 when the bearing was first produced and sold and not during or immediately prior to the base period. See Monarch Cap Screw & Manufacturing Co. 5 TC 1220.
* * * *
Further in support, the petitioner claimed:
The Morgan situation would look much worse than it does, and, therefore, relief would be even more clearly indicated than it is now, were it not for the fact that, in 1933, Morgan invented and began to manufacture an entirely new product called "Morgoil." The figures which we have used for the base period years reflect the results of Morgoil but the figures which we have used for the prior years do not reflect it. The result is that the picture which we present is much brighter than it should be, and should this matter not be settled, and should it come to trial, we would expect to deduct the Morgoil from the base period figures. In that connection it is noted that Morgoil, while constituting none of the Company's business from 1910 to 1929, constituted something like 40% of its business in the base period. Attached hereto is a schedule*64 showing total sales in the base period years and the Morgoil sales included therein * * *.
Morgoil was a very profitable business, and even if we should assume that it paid only 10 cents on the dollar profit in the base period, it would materially alter the base period figures for the purpose of Section 722.
* * * *
The petitioner changed the character of its business immediately prior to or during the base period when the manufacture and sale of Morgoil bearings became a part of its activities.
Petitioner's business had not reached the earning level by the end of the base period that it would have reached if the change in its business had taken place 2 years earlier than it did.
If the petitioner had made the change in its business 2 years earlier, its average base period earnings would have been increased by $ 35,000.
*252 OPINION.
The evidence, in our opinion, shows that the invention, development, and sale of the Morgoil bearings constituted a change in the character of petitioner's business within the meaning of section 722 (b) (4). The respondent while contending that the manufacture and sale of Morgoil bearings did not constitute a change within the meaning of the section*65 puts his chief argument on his contention that the change that took place was not "during or immediately prior to the base period" within the meaning of section 722 (b) (4).
The evidence before us establishes that, while the smaller bearings were being produced in considerable quantities and were well known to the rolling mill industry by 1935, the larger bearings from which the profits were chiefly made found no market until 1935, and the actual development period for these bearings extended until near the end of 1939, the last year of petitioner's base period. For instance, the thrust bearing defects, one of the most serious experienced by the petitioner, did not develop until late in the base period and were not corrected until near the close of 1939. This was the last change made in the basic design of the bearings up to the present time.
Throughout the base period, the petitioner was required to make large expenditures for research and experimentation in an effort to correct defects in the bearings. Also, it found it necessary to work out new methods of manufacturing the bearings, and it was necessary to install a large amount of new machinery to meet production requirements. *66 As a result, petitioner's net profits on its base period sales of bearings were abnormally low. Thus, it seems to us that under the statute, as construed by the Commissioner's regulations, 1 the change in the character of the business must be considered as having taken place "during or immediately prior to the base period."
*67 In its reconstruction of base period income, the petitioner proposes to increase 1939 sales of Morgoil bearings from $ 816,576.04, actual, to *253 a minimum of $ 1,140,501.39, and to correspondingly increase gross profits from $ 186,090.12, actual, to a minimum of $ 377,505.93.
Petitioner would also increase gross profits by applying to 1939 constructive sales the increased ratio of gross profits to sales established in 1941, the theory being that with 2 years' additional experience from 1939 the defects and abnormal production costs would have been eliminated and a higher normal ratio of gross profits to sales established.
In our opinion, the evidence fails to establish what additional sales of Morgoil bearings, if any, petitioner would have had in 1939, or in any year of the base period, if the change in its business had taken place 2 years earlier than it did. Petitioner could only sell the bearings when and as the rolling mill industry was ready to purchase them. That depended to a large extent on the progress of the industry itself, and particularly the increase in demand for the products of the large roll, high-speed mills. The peak demand for the small type bearings*68 apparently was reached in 1936 when 704 of them were sold. Only 8 were sold in 1939 as against 21 of the larger type. There is no convincing evidence that the industry would have been ready to absorb any appreciably greater number of the larger bearings during the base period even if the defects had been earlier corrected.
The manufacturing costs of the bearings were abnormally high during the base period years due to the large expenditures required for research, experimentation, development of manufacturing technique, and for correcting operational defects in bearings already installed. With 2 years' additional experience, most of the defects would have been eliminated and the production costs materially decreased by the end of the base period. Petitioner's records show that there was a substantial reduction in manufacturing costs in 1941 over the base period average.
While there are no available records for a mathematically accurate computation of the amount of the additional net income that would have resulted from such earlier change, there is evidence before us on which a reasonable estimate can be made. Giving effect to the numerous factors for which adjustments must be*69 made in the reconstruction of petitioner's base period income, we have concluded and have found as a fact that with such earlier change, petitioner's average base period net income would have been increased by $ 35,000.
One other issue calls for disposition.
The respondent contends that the facts presently relied on by the petitioner in respect of the development of the Morgoil bearings and the figures essential to any reconstruction of base period income attributable thereto cannot be considered by this Court because they *254 were not submitted to him with or in support of the claims for relief. Blum Folding Paper Box Co., 4 T. C. 795. We disagree with the respondent's interpretation of the claims submitted by the petitioner. We think that those claims, as originally submitted, clearly identify the principal factors upon which the petitioner was requesting relief and that among these were the invention and development of the Morgoil bearing as a ground for relief under subsection (b) (4). The respondent fully considered and rejected the claims as presented.
It may be conceded that the theory advanced in our reconstruction and the figures we*70 have used pertaining to the excessive production costs of the Morgoil bearings were not furnished to the Commissioner during his administrative consideration of the claims for relief, but we do not think this is fatal under our holding in the Blum case. As we said in Trunz, Inc., 15 T. C. 99, the Blum case "did not hold that evidence to support facts stated in the applications would have to be the same as that presented to the Commissioner or that the taxpayer would have to set forth in its application the evidence upon which it relied to establish facts stated therein, and it did not say anything about methods of computing constructive average base period net income or restrict the taxpayer as to theories relating to that question."
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. Regulations 112.
Sec. 35.722-3. Determination of Excessive and Discriminatory Tax; Taxpayer Entitled to Excess Profits Credit Based on Income. --
(d) Commencement or change in character of business. -- * * *
No arbitrary temporal limitations can be provided to circumscribe the concept of "immediately prior to the base period" for the purposes of section 722 (b) (4) in the case of a business commenced or changed in character at such time. * * * Generally, business experiences a time lag between the time that new operations are commenced, reflecting either the starting of a new business or of a business essentially different in character from an old business, and the attainment of a normal earning level. If all or a portion of this time lag occurs during the base period, the earnings during such period cannot be said to represent normal average earnings.
Generally, the commencement of business or the change in character of a business will be deemed to have occurred immediately prior to the base period if under normal conditions the normal earning level of a business so commenced or changed would not be realized until some time during the base period and would be principally and directly related to such commencement or change. * * *↩