*251 Decision will be entered under Rule 50.
1. Petitioner, an oil well drilling contractor, seeks qualification to reconstruct average base period net income under section 722 (b) (1) and (2) because of a lawsuit instituted by one of its two equal stockholders praying for its dissolution and distribution of its assets during the base period. Held, petitioner is qualified under subsection (b) (1). Constructive average base period net income determined.
2. Petitioner seeks qualification under section 722 (b) (4) because of a change in its character resulting from a transfer of a portion of its business operation from Wyoming to California during the base period. Held, petitioner is not qualified under subsection (b) (4) because such move did not change the character of its business within the meaning of that subsection. Petitioner also seeks qualification under subsection (b) (4) because of an increase in its capacity for operation or production growing out of its acquisition during the base period of additional oil well drilling equipment. Held, petitioner is not qualified under subsection (b) (4) because it has failed to show an increase in its base period income *252 attributable to such additional equipment.
*1195 FINDINGS OF FACT.
Petitioner was incorporated under and by virtue of the laws of the State of Wyoming on August 22, 1931, and since that date has been engaged in the business of drilling oil wells. It filed timely income and declared value excess-profits tax returns (Form 1120) and excess profits tax returns (Form 1121) for all taxable years here involved with the collector of internal revenue for the sixth district of California. It kept its books and filed its tax returns on the basis of the accrual method of accounting and on the basis of fiscal years ending July 31.
During its base period years petitioner's excess profits net*253 income, as finally determined by respondent, was as follows:
| Year ended | |
| July 31 | Excess profits net income |
| 1937 | $ 45,211.80 |
| 1938 | 135,974.30 |
| 1939 | (539.50) |
| 1940 | (15,281.97) |
In determining the amount stated above as excess profits net income for the fiscal year ended July 31, 1938, respondent disallowed a deduction *1196 in the amount of $ 80,632.95 representing intangible drilling and development costs on oil wells drilled for petitioner's own account, pursuant to section 711 (b) (1) (I), Internal Revenue Code of 1939.
In determining the amounts stated above as excess profits net income for the fiscal years ended July 31, 1939 and 1940, respondent disallowed deductions in the amounts of $ 21,699.21 and $ 5,763.39, respectively, pursuant to section 711 (b) (1) (J) (ii) of the 1939 Code, representing abnormal expense of moving petitioner's headquarters and certain equipment from Wyoming to California.
Since petitioner was in existence before January 1, 1940, it is entitled to compute its excess profits credit in accordance with the provisions of either section 713 or section 714 of the 1939 Code, and to use whichever amount results in the lesser excess profits*254 tax, as provided by section 712 (a) of the 1939 Code.
Petitioner's excess profits credit, as finally computed by the respondent, in accordance with the provisions of section 713 (e) of the 1939 Code, but without the application of section 722 of such Code, for each of the taxable years here involved, is $ 53,629.46, being 95 per cent of an average base period net income of $ 56,452.06. In addition, and without the benefit of relief under section 722 of such Code, petitioner is entitled to and has been allowed a carryover of unused excess profits credit from prior years to the taxable year ended July 31, 1944, in the sum of $ 54,134.47; also, a carryback of an unused excess profits credit from the taxable year ended July 31, 1947, to the taxable year ended July 31, 1945, in the sum of $ 22,480.29.
Petitioner's excess profits tax liability and the deficiency or overpayment for each of the years in controversy, as finally determined by the respondent, and without relief under section 722 of the 1939 Code, are as follows:
| Year ended | Excess profits | ||
| July 31 | tax liability | Deficiency | Overpayment |
| 1944 | $ 87,988.45 | 1 | 1 |
| 1945 | 41,579.94 | 1 | 1 |
| 1946 | 91,489.80 | $ 25,065.94 | 1 |
In determining the excess profits tax liability for the year ended July 31, 1945, respondent allowed a net operating loss carryback from the year ended July 31, 1947, in the sum of $ 141,930.56.
Petitioner filed with respondent timely applications for relief under section 722 of the 1939 Code (Form 991). Such applications for relief were thereafter supplemented by various documents and letters filed with respondent by the petitioner. In its petition herein and in its applications for relief, petitioner claimed that it was entitled to a constructive average base period net income of $ 243,929.03 and to relief under each subparagraph of section 722 (b), i. e., section 722 (b) (1), (2), (3), (4), and (5).
*1197 Petitioner was organized by Lloyd Noble and Dorsey E. Straitiff, and each owned a 50 per cent interest in the business. Its capital stock, which consisted of 4 shares, par value $ 100 per share, was issued equally to Noble and Straitiff. No additional stock was ever issued.
In 1931 and thereafter, Noble resided in Ardmore, Oklahoma. He was a well known drilling contractor in the Mid-Continent oil fields. Noble operated with rotary drilling equipment and*256 one of his companies had drilled a well in Wyoming prior to the organization of the petitioner. In 1931 and prior thereto, Straitiff was a cable-tool drilling contractor in Wyoming and other Rocky Mountain States. He had been so engaged since 1923 but was interested in changing over to rotary drilling. Straitiff considered Noble one of the best drilling operators in the field.
After its organization petitioner contracted with Noble, or one of his companies, for three rotary drilling rigs for approximately $ 175,000. Between August 1931 and late in 1934, Noble loaned or advanced to petitioner, or caused to be loaned or advanced to it, money or equipment aggregating $ 497,596.95. Due to repayments on this indebtedness the highest amount ever owed by petitioner to Noble, or one of his companies, at any one time was $ 274,206.95. By the end of 1934 these advances and indebtedness had been repaid, and neither Noble nor one of his companies made further loans or advances to petitioner.
From 1931 to 1935 Noble and Straitiff were petitioner's only directors and its principal officers. Petitioner's board of directors met once each year, in August, at the time of the annual stockholders' *257 meeting. During these 4 years Noble was president and Straitiff was vice president and secretary. Noble took no active part in the conduct of petitioner's drilling operations during this period, and all managerial decisions were made by Straitiff, who resided in Wyoming.
By August of 1935 friction between Noble and Straitiff had developed to such an extent that Noble resigned from the presidency and from petitioner's board of directors. In a letter of resignation, dated August 22, 1935, Noble stated: "I have not been consulted as to purchases made during the fiscal [years] of 1934 and 1935. Not having assented to the same I hereby protest any personal liability should any action later arise against the members of the Board of Directors of your Company." Straitiff, as vice president, continued to operate petitioner's business after Noble resigned, and was elected president in February 1937.
Petitioner's growth and expansion are reflected in the following table and figures covering surplus and other accounts for the fiscal years July 31, 1932, through July 31, 1938: *1198
| Fiscal year | Wells | Footage | Gross | Net operating | |
| started | drilled | contract | Gross | income | |
| receipts | profit | (or loss) | |||
| 1932 1 | 6 | 81,793 | $ 266,169 | $ 2,121 | ($ 36,300) |
| 1933 1 | 11 | 226,128 | 54,712 | (2,444) | |
| 1934 1 | 12 | 239,852 | 60,741 | 18,692 | |
| 1935 | 17 | 52,374 | 472,345 | 154,752 | 87,639 |
| 1936 | 27 | 118,345 | 1,177,933 | 286,660 | 133,191 |
| 1937 | 41 | 160,840 | 1,468,075 | 340,173 | 34,999 |
| 1938 | 25 | 165,258 | 1,565,931 | 493,725 | 155,301 |
Petitioner's earned surplus for the fiscal years 1935 to 1938, inclusive, increased as follows: 1935 -- $ 82,086.02; 1936 -- $ 214,711; 1937 -- $ 258,845.79; 1938 -- $ 347,451.83. Its drilling rigs increased from 3 in 1931 to 14 in December 1937. Its machinery and equipment account at July 31, 1937, and at July 31, 1938, was in excess of $ 1,000,000. Its notes payable account at July 31, 1937, and July 31, 1938, showed an indebtedness of $ 739,838.42 and $ 299,000, respectively.
On December 14, 1937, Noble sued petitioner and Dorsey E. Straitiff in the United States District Court for the District of Wyoming, No. 2616 -- In Equity, asking for the appointment of a receiver and the liquidation of the petitioner. On February 21, 1938, he amended his bill of complaint setting forth in more detail the alleged wrongful acts of Straitiff and the petitioner. On May 18, 1938, petitioner and Straitiff filed an answer which denied generally and in detail any wrongdoing on their part and asked for*259 dismissal of the suit.
In December 1938, the litigation was settled out of court. Noble and petitioner executed a written agreement, dated November 1, 1938, which stated that they desired "to provide for a partial liquidation of said Company [petitioner] and to the extent of the said Noble's one-half interest in said Company: * * *." Under the terms of the agreement petitioner was to pay Noble $ 18,500 cash and convey to him the various properties described in the agreement. Noble agreed to accept the cash and property in full liquidation of his half interest and to transfer his 2 shares of stock to petitioner for cancellation. The agreement further recited that a considerable amount of the property described was subject to a lien of $ 299,000, and that the parties would bear this indebtedness equally, subject to the creditor's agreement to look to each for one-half thereof. Disposition of Noble's 50 per cent interest in the petitioner was effected in accordance with the terms of such agreement.
Between the commencement of the litigation and the settlement thereof petitioner sold 2 of its 14 drilling rigs in order to reduce its outstanding indebtedness. At the settlement, petitioner*260 took 6 of the 12 drilling rigs remaining and Noble took the other 6. Noble operated *1199 his 6 rigs in the Rocky Mountain area in competition with the petitioner.
Pursuant to the terms of the agreement, Noble's shares of capital stock were transferred to petitioner and were canceled. Thereafter, petitioner's outstanding capital stock totaled $ 200.
Noble's suit, requesting a receivership for the petitioner and its liquidation, affected petitioner's business adversely. Drilling contracts dropped after the suit was filed. Between August 1, 1937, and December 31, 1937, petitioner started 18 wells; during the remaining 7 months of the fiscal year it started only 7 wells. The first well contracted for by an oil company after Noble filed suit was started on March 10, 1938. Additional wells drilled under contract were started as follows: 1 in April, 2 in May, and 3 in June of 1938. All wells started during the fiscal year 1938 were in the Rocky Mountain States.
Approximately 90 per cent of petitioner's drilling contracts were at an agreed price per foot drilled, and its remaining contracts were at an agreed price per day regardless of the footage drilled. A summary of the total*261 footage drilled, footage drilled in Wyoming, number of wells started and completed during stated portions of petitioner's fiscal years 1936-1940, inclusive, follows:
| Period | Total footage | Wyoming | Wells | Wells |
| footage | started | completed | ||
| August to December 1935 | 54,660 | 46,067 | 12 | 14 |
| January to July 1936 | 63,685 | 55,499 | 15 | 13 |
| August to December 1936 | 80,034 | 64,397 | 20 | 19 |
| January to July 1937 | 80,806 | 63,568 | 21 | 18 |
| August to December 1937 | 93,097 | 81,468 | 18 | 19 |
| January to July 1938 | 72,161 | 63,969 | 7 | 18 |
| August to December 1938 | 35,057 | 29,519 | 7 | 7 |
| January to July 1939 | 51,081 | 32,388 | 11 | 11 |
| August to December 1939 | 48,871 | 30,915 | 11 | 9 |
| January to July 1940 | 119,192 | 74,039 | 14 | 16 |
During the calendar years 1936-1939, inclusive, petitioner completed 114 wells located in the following States: Wyoming -- 97; Montana -- 5; Colorado -- 3; Utah -- 5; California -- 4. It was petitioner's policy to engage in deep-well drilling operations where possible. A comparison of the footage drilled by petitioner in Wyoming with the footage drilled by all other concerns follows:
| Calendar years | Total footage | Petitioner's | Percentage |
| Wyoming | footage | petitioner's | |
| Wyoming | footage of | ||
| total | |||
| Per cent | |||
| 1936 | 269,725 | 119,896 | 44 |
| 1937 | 344,155 | 145,036 | 42 |
| 1938 | 298,767 | 93,488 | 31 |
| 1939 | 431,351 | 63,303 | 15 |
*262 *1200 Petitioner's share of the total wells completed in Wyoming, for stated portions of its fiscal years, follows:
| Petitioner's | |
| share of total | |
| Period | per cent |
| August to December 1935 | 20 |
| January to July 1936 | 24 |
| August to December 1936 | 24 |
| January to July 1937 | 27 |
| August to December 1937 | 30 |
| January to July 1938 | 16 |
| August to December 1938 | 10 |
| January to July 1939 | 14 |
| August to December 1939 | 9 |
Petitioner's operating results for the fiscal years 1939 and 1940 showed a marked decline from the fiscal year 1938:
| Total footage | ||||
| drilled by | Gross contract | Operating | ||
| Fiscal year | petitioner | receipts | Gross profits | income (or loss) |
| 1938 | 165,258 | $ 1,565,931 | $ 493,725 | $ 155,301 |
| 1939 | 86,138 | 645,586 | 207,123 | 4,066 |
| 1940 | 168,063 | 1,205,592 | 268,512 | (6,624) |
Its earned surplus at July 31, 1939, was $ 162,193.73, and at July 31, 1940, was $ 139,796.91. Its machinery and equipment account at the end of the fiscal years 1939 and 1940 was $ 664,254 and $ 943,951, respectively. Its notes payable account for the same years was $ 393,482 and $ 122,870, and in addition, for the fiscal year 1940, its conditional sales contract payable account amounted*263 to $ 337,010.
The decline in petitioner's business in the fiscal year 1939 was due in large measure to Noble's suit for dissolution. To some extent its residual effect was also a depressant during the remainder of that year. Straitiff, distracted by the litigation, was unable to devote his entire time and attention to the business. The litigation placed a severe strain on petitioner's credit and working capital at a time when it was heavily indebted for drilling rigs. The litigation created apprehension among the oil companies as to petitioner's ability to complete its contracts. The ownership and use of only half of its drilling rigs subsequent to May or June 1938 resulted from its partial liquidation on settlement of the litigation.
After the litigation was settled, petitioner was reduced to 6 drilling rigs, one of which was discarded shortly thereafter because it was obsolete. During the calendar year 1939 petitioner purchased 2 additional drilling rigs, one at a cost of $ 234,183.58 and the other at a cost of $ 174,165.33. By July 31, 1941, petitioner had 8 drilling rigs. By July 31, 1942, petitioner had 12 rigs, which were the rigs used during the taxable years herein. *264 The number of drilling rigs in operation at the end of each month during 1939 was as follows: *1201
| Rigs in use at | |
| 1939 | end of month |
| January | 2 |
| February | 2 |
| March | 3 |
| April | 2 |
| May | 3 |
| June | 5 |
| July | 6 |
| August | 4 |
| September | 3 |
| October | 5 |
| November | 6 |
| December | 4 |
Prior to the spring of 1939, petitioner had confined its operations to the Wyoming-Colorado mountain area. In the spring of 1939, however, petitioner transferred two of its drilling rigs to California. Subsequently, additional drilling rigs were transferred from the Rocky Mountain area to California as petitioner's drilling activities therein expanded.
A comparison of California and Wyoming in wells drilled, footage drilled, and average depth per well, follows:
| Wells drilled | Footage drilled | Average depth per well | ||||
| Calendar | ||||||
| year | ||||||
| California | Wyoming | California | Wyoming | California | Wyoming | |
| 1936 | 1,123 | 102 | 4,634,528 | 269,725 | 4,127 | 2,644 |
| 1937 | 1,470 | 105 | 5,970,047 | 344,155 | 4,061 | 3,277 |
| 1938 | 1,270 | 108 | 6,110,796 | 298,767 | 4,850 | 2,761 |
| 1939 | 1,116 | 130 | 6,253,634 | 431,351 | 5,603 | 3,318 |
| 1940 | 1,030 | 143 | 6,431,940 | 480,991 | 6,245 | 3,364 |
During the calendar year 1939 petitioner drilled*265 4 wells in California with a total footage of 34,043 feet out of a total footage for the year of 99,952 feet for the 20 wells drilled. During the calendar year 1940 petitioner's footage drilled in California and Wyoming was 71,764 feet and 71,326 feet, respectively.
For the fiscal years ended July 31, 1935 to 1939, inclusive, petitioner's gross profit as a percentage of its gross receipts, its gross profit per well, and its gross profit per foot drilled, were as follows:
| Gross profit | |||
| as a percentage | Gross profit | Gross profit | |
| Fiscal year | of gross | per well | per foot |
| receipts | |||
| Per cent | |||
| 1935 | 33 | 1 $ 11,904 | $ 2.95 |
| 1936 | 24 | 10,617 | 2.42 |
| 1937 | 23 | 9,194 | 2.11 |
| 1938 | 32 | 2 14,106 | 2 3.10 |
| 1939 | 32 | 11,507 | 2.40 |
The litigation, its settlement, and petitioner's partial liquidation were the first and only events of this nature in petitioner's history. *266 *1202 Except for the consequences flowing from the former event, petitioner's ability to obtain drilling contracts from the oil companies operating in Wyoming remained unimpaired.
The stipulated facts, oral and written, are so found and are incorporated herein by reference.
Joint Exhibits 3-C, 4-D, 5-E, 9-H, and 10-I, being Excess Profits Credit as Determined by Respondent; Operating Income Statements, Fiscal Years 1935 to 1940, Inclusive; Balance Sheets, Fiscal Years 1935 to 1940, Inclusive; Analysis of Miscellaneous Accounts, 1935 to 1940, Inclusive; and Wells Completed, Fiscal Years 1932 to 1945, Inclusive, respectively, are incorporated herein by reference. Many of the facts contained in these exhibits have been hereinbefore summarized in our findings but the details thereof, due to the size and length of the exhibits, can be included only by this reference.
OPINION.
Petitioner seeks to establish its qualification to reconstruct its base period income on all subparagraphs of section 722 (b) of the Internal Revenue Code of 1939. We find it to be so qualified under subsection (b) (1).
The litigation inaugurated by Noble in December 1937 had a depressant effect upon the income*267 of petitioner for its fiscal year 1939 and to some extent for the remainder of that year as we have factually found. Its actual net profit for that period does not therefore provide an adequate basis with which to measure excessive profits of postbase-period years because such net profit would have exceeded the actuality provided the litigation had not been instituted.
The suit for dissolution of petitioner was unique in its history and temporary in its effect as contrasted with the settlement of the suit which, though unique, was a permanent change so far as base period years are concerned.
Since we have found qualification under subsection (b) (1) and since the facts relied upon for qualification under subsection (b) (2) are the same as those relied upon for qualification under the former subsection, we do not find it necessary to consider the (b) (2) issue. Southern California Edison Co., 19 T. C. 935. Petitioner fails to show any evidentiary basis for qualification under either subsection (b) (3) or (b) (5). In urging qualification under subsection (b) (4), petitioner points to two factors, the first of which is its change of operational situs*268 from Wyoming to California and, secondly, to its increase in capacity arising through acquisition of two additional drilling rigs in 1939. We are not convinced that either is a factor for such qualification.
*1203 Petitioner's drilling operations prior to its move to California while primarily confined to Wyoming had been consistently carried on to a substantial extent in other States contiguous thereto. The only real difference in its operation was that in California deeper drilling was regularly performed. This however is not a qualifying change because it is a difference only in degree not in character. It is noted too that petitioner in engaging in deep-well drilling in California was but furthering its long standing policy of performing such drilling even while operating in the Wyoming area.
Petitioner's acquisition of additional drilling rigs in 1939 is not shown to be a qualifying change in its character. Such acquisitions permitted growth of its business but are not shown to have caused any increase. We have heretofore held that mere increased capacity without a showing that growth is attributable thereto is insufficient for (b) (4) qualification. Helms Bakeries, 23 T. C. 967;*269 Green Spring Dairy, Inc., 18 T. C. 217. At no time during the base period after it obtained the new rigs and thus raised the total number thereof to 7 were more than 6 in use at the end of a month. The average number in use at the close of each month in 1939 was only about 4. We think it is a fair conclusion from the record that the partial dissolution of petitioner, coupled with the competition of Noble, is responsible for petitioner's failure to capture sufficient business to utilize its increased capacity. As we have held above, these factors are permanent in nature and therefore not indicative of qualification.
In our reconstruction of average base period net income, we must eliminate as a factor any fact or circumstance which would tend to alter from the normal the environment in which petitioner's base period business was carried on. The factor which does so tend is the suit for liquidation with its attendant disruption of petitioner's management, loss of confidence in petitioner's ability to perform its drilling contracts on the part of potential owners of drilling rights, and the resulting decline in the number of such contracts. No attempted*270 allocation of petitioner's losses in number of wells drilled, total yearly footage drilled, percentage of wells drilled in its operating area, or other such categories, is made on brief or otherwise by petitioner with respect to the abnormalcies claimed. We think it reasonable to conclude, however, that its base period experience during the years 1938 and 1939 was abnormal to an appreciable extent because of the institution and continuance for approximately 1 year of Noble's suit for dissolution. That it adversely affected petitioner's business operation for the remainder of the base period seems clear.
After careful consideration of the record and the briefs of the parties, we hold that petitioner is entitled to use the amount of $ 68,000 as its constructive average base period net income.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. None.↩
1. The figures for the first 3 years are not on a basis comparable to the later years, but the net operating income (or loss) shown is substantially equivalent to excess profits net income.↩
1. Based on 13 wells completed during fiscal year 1935.↩
2. Based on 35 wells completed and 159,118 feet drilled, because 2 wells aggregating 6,140 feet were for petitioner's own account, the cost of drilling of which was excluded from cost of operations and produced no income reflected in gross contract receipts.↩