*268 Decision will be entered under Rule 50.
The petitioner challenged as inadequate the relief accorded to it by the Commissioner by reason of certain changes in the character of its business which qualified it for relief under section 722 (b) (4) of the Internal Revenue Code. Constructive average base period net income determined.
*900 The respondent has disallowed in part the petitioner's applications for relief under the provisions of section 722 of the Internal Revenue Code for the fiscal years ended August 31, 1941, through August 31, 1946, respectively, and has determined deficiencies in petitioner's excess profits tax in the amounts*269 of $ 22,646.41, $ 23,485.18, $ 21,514.10, and $ 7,691.50 for the fiscal years ended August 31, 1943, 1944, 1945, and 1946, respectively.
By his affirmative allegation the respondent has claimed an additional deficiency for the petitioner's excess profits tax year ended August 31, 1941, of $ 301.25, which results from errors in respondent's original computation of the petitioner's excess profits credit for the fiscal year ended August 31, 1941, which was computed without the benefits of section 722. The deficiencies as determined represent portions of the petitioner's liability for excess profits taxes as shown on its excess profits tax returns, the payment of which was partially deferred under the provisions of section 710 (a) (5) of the Internal Revenue Code.
The question for our decision is whether the petitioner's actual average base period net income computed under section 713 (f) of the fiscal year ended August 31, 1941, and $ 94,000 for the fiscal year ended August 31, 1942, and $ 100,000 for the fiscal years ended August 31, 1943, through August 31, 1946, represent fair and just amounts representing normal earnings to be used by the petitioner as a constructive average base*270 period net income as determined by the respondent.
*901 FINDINGS OF FACT.
The facts stipulated by the parties are found accordingly.
The petitioner was incorporated under the laws of the State of North Carolina on March 4, 1903, as Lily Mill & Power Company. The name was changed to Lily Mills Company on July 16, 1934. At all times pertinent to this proceeding the petitioner has kept its books on the accrual basis of accounting and on the basis of a fiscal year ended August 31. The income tax and excess profits tax returns for the period here involved were filed with the collector of internal revenue for the district of North Carolina. Petitioner's base period years consisted of the fiscal years ended August 31, 1937, through August 31, 1940.
The petitioner filed the following applications for relief (Form 991) under section 722 of the Code:
| Years ended | |
| Aug. 31 | Date filed |
| 1941 and 1942 | Sept. 1, 1943 |
| 1943 | May 17, 1944 |
| 1944 | Mar. 10, 1945 |
| 1945 | Jan. 14, 1946 |
| 1946 | Oct. 28, 1946 |
Supplemental information in connection with these claims was filed on February 11, 1946, and May 6, 1948.
The general basis of the petitioner's applications for relief was that it had changed*271 the character of its business during the base period and that its business did not reach the earnings level by the end of the base period which would have been reached had the changes been initiated 2 years earlier than they were. The changes in the character of the business relied upon by the petitioner were (1) the establishment during the base period of two domestic branch warehouses and a Cuban agency, and (2) the addition of Article No. 241, a fluff rug yarn, to its line of business.
While recognizing that the petitioner was entitled to relief under section 722 (b) (4) of the Code for the changes in character set forth above, the respondent disallowed in part the petitioner's claim for relief and determined the petitioner's constructive average base period net income and deficiencies in excess profits tax as shown above.
At the time of its incorporation the petitioner manufactured combed yarn. Shortly after its incorporation it began to specialize in thread yarn for the manufacturing trade. In 1927 the production of sewing thread for domestic consumption was begun which was soon followed by the addition of a line of needlecraft products for home use. It was petitioner's custom*272 to manufacture most of its products for reasons of economy and service. However, some were purchased *902 for resale. Experimental items in the petitioner's line or to be added to the petitioner's line were purchased for resale from others for the reason that it eliminated the necessity of setting up for manufacture of small lots.
The petitioner was not a closely held corporation. The shares were widely distributed although a large, but minority, interest of its shares was owned by the Schenck family. J. W. Schenck, who held the title of secretary from 1921 through the base period, was primarily responsible for the management of the petitioner. Schenck's father was president of petitioner during this period; however, his duties were advisory. Schenck and the other officials of the corporation were paid nominal salaries plus bonuses based on profits, with the exception of Schenck's father, who received a nominal salary of $ 100 per month.
Petitioner was not affected by the general recession of 1938. Its sales increased in a constant trend from 1936 through 1948.
Petitioner's business during the base period consisted of the manufacture or jobbing of combed yarn and a line*273 of needlecraft products. The sales of the combed yarn and needlecraft line from the plant at Shelby, North Carolina, were normal sales in the sense that they consisted of the same products, distributed in the same manner as in pre-base period months. The sales of the needlecraft line were also made through branch warehouses. The negligible sales of Article No. 241 made during the base period were sales of a new product using both the old and new methods of distribution.
After the addition of a line of needlecraft products in 1927, the petitioner contracted with a South Carolina sales organization to act as its sales department. This arrangement continued in effect through 1934. The petitioner set up its own sales office in 1934 and from 1935 all sales were made by its own sales force. Prior to 1936 all sales orders were filled by shipments from the plant at Shelby, North Carolina. After the petitioner established its own sales force, it began to advertise on a national scale.
In 1936 a full line of needlecraft products was on the market, including crochet and knitting cotton yarns, thread, and twines, all of which appeared on price lists sent out to the trade. These price *274 lists indicated the list price of all items offered for sale. Terms extended included a trade discount which applied to all purchasers and a 2 per cent 10-day cash discount. Occasionally special prices were quoted to jobbers and chain stores on sewing threads.
Prices were established after consultation between J. W. Schenck and the sales manager and were based on three factors: Cost, competition, and resale. These prices were then listed, sent to the printer for printing, and then were dispatched by third class mail to salesmen *903 and to the trade. Each price list had an effective date and in order to get them out to the trade by the effective date, at least 2 or 3 weeks had to be allowed for the time involved in preparation and mailing.
Salesmen were paid on a commission basis exclusively, figured on their individual volume of sales. Commissions, like prices, fluctuated and varied according to the individual items sold. Salesmen were apprised of these commission rates, as well as amendments thereto, by means of letters or mimeographed quotations sent out by first class mail. There was usually a lapse of time between the decision to issue a new commission rate and the*275 receipt of this information by the salesmen due to the time required for printing and mailing. Extra commissions or bonuses were generally paid to salesmen where a new territory was being opened or to stimulate sales on highly competitive items that were meeting sales resistance. High commissions were also used to promote the sales of new or experimental products.
The American Thread Company and the Spool Thread Company controlled about 90 per cent of the business available to petitioner. Petitioner has demonstrated a consistent ability to meet this competition.
A summary of the results of petitioner's operations during the base period follows:
| Taxable year ended Aug. 31 | |||
| 1936 | 1937 | 1938 | |
| Net sales (after returns, | |||
| allowances, discounts, bad | |||
| debts & certain expenses) | $ 1,041,669.02 | $ 1,149,632.16 | $ 1,344,948.36 |
| Cost of sales (including | |||
| combined manufactured goods | |||
| and purchased goods, and | |||
| cost of shipping for all goods) | 809,302.93 | 884,342.29 | 1,014,886.71 |
| Gross profit | $ 232,366.09 | $ 265,289.87 | $ 330,061.65 |
| Expenses: | |||
| Commissions (including sales | |||
| commissions & branch | |||
| warehouse commissions not | |||
| separable) | $ 82,770.02 | $ 95,946.91 | $ 117,483.83 |
| Freight & postage on sales | |||
| (including California & Marietta | |||
| branch warehouse expense | |||
| which is actually freight & | |||
| postage) | 60,379.23 | 68,911.57 | 78,456.36 |
| Advertising | 29,032.57 | 39,257.22 | 63,152.02 |
| Salaries & general expenses | |||
| attributable to selling | 28,596.87 | 29,788.06 | 34,396.26 |
| Total expenses -- Selling | $ 200,778.69 | $ 233,903.76 | $ 293,488.47 |
| Operating profit | $ 31,587.40 | $ 31,386.11 | $ 36,573.18 |
| Other income: | |||
| Refund processing tax and | |||
| interest * | $ | $ 1,183.07 | $ |
| All other | 2,177.14 | 1,258.08 | 1,972.43 |
| Total other income | $ 2,177.14 | $ 2,441.15 | $ 1,972.43 |
| Total income | $ 33,764.54 | $ 33,827.26 | $ 38,545.61 |
| Less: | |||
| State income tax & declared | |||
| value excess profits taxes | 2,025.88 | 2,035.37 | 2,322.42 |
| Statutory excess profits net | |||
| income | $ 31,738.66 | $ 31,791.89 | $ 36,223.19 |
| * Abnormal income to be | |||
| removed | 1,183.07 | ||
| Excess profits net income after | |||
| removal of this abnormality | $ 31,738.66 | $ 30,608.82 | $ 36,223.19 |
| Taxable year ended Aug. 31 | ||
| 1939 | 1940 | |
| Net sales (after returns, | ||
| allowances, discounts, bad | ||
| debts & certain expenses) | $ 1,720,936.91 | $ 1,781,060.73 |
| Cost of sales (including | ||
| combined manufactured goods | ||
| and purchased goods, and | ||
| cost of shipping for all goods) | 1,298,476.23 | 1,327,314,95 |
| Gross profit | $ 422,460.68 | $ 453,745.78 |
| Expenses: | ||
| Commissions (including sales | ||
| commissions & branch | ||
| warehouse commissions not | ||
| separable) | $ 150,507.89 | $ 150,632.24 |
| Freight & postage on sales | ||
| (including California & Marietta | ||
| branch warehouse expense | ||
| which is actually freight & | ||
| postage) | 92,659.55 | 102,252.36 |
| Advertising | 74,073.73 | 81,795.94 |
| Salaries & general expenses | ||
| attributable to selling | 38,859.59 | 42,652.10 |
| Total expenses -- Selling | $ 356,100.76 | $ 377,332.64 |
| Operating profit | $ 66,359.92 | $ 76,413.14 |
| Other income: | ||
| Refund processing tax and | ||
| interest * | $ | $ 25,935.00 |
| All other | 1,228.47 | 1,784.26 |
| Total other income | $ 1,228.47 | $ 27,719.26 |
| Total income | $ 67,588.39 | $ 104,132.40 |
| Less: | ||
| State income tax & declared | ||
| value excess profits taxes | 4,832.28 | 6,247.94 |
| Statutory excess profits net | ||
| income | $ 62,756.11 | $ 97,884.46 |
| * Abnormal income to be | ||
| removed | 25,935.00 | |
| Excess profits net income after | ||
| removal of this abnormality | $ 62,756.11 | $ 71,949.46 |
| Percentage to Sales | |||||
| Taxable years ended Aug. 31 | |||||
| Per cent | |||||
| 1936 | 1937 | 1938 | 1939 | 1940 | |
| Net sales | 100.0 | 100.0 | 100.0 | 100.0 | 100.0 |
| Cost of sales | 77.69 | 76.92 | 75.46 | 75.45 | 74.52 |
| Gross profit | 22.31 | 23.08 | 24.54 | 24.55 | 25.48 |
| Expenses: | |||||
| Commissions | 7.95 | 8.35 | 8.73 | 8.75 | 8.46 |
| Freight and postage | 5.80 | 5.99 | 5.83 | 5.38 | 5.74 |
| Advertising | 2.79 | 3.42 | 4.70 | 4.30 | 4.59 |
| Salaries and general | 2.74 | 2.59 | 2.56 | 2.26 | 2.40 |
| Total selling expenses | 19.28 | 20.35 | 21.82 | 20.69 | 21.19 |
| Operating profit | 3.03 | 2.73 | 2.72 | 3.86 | 4.29 |
| Other income: | |||||
| Refund processing tax and | |||||
| interest | .10 | 1.46 | |||
| All other | .21 | .11 | .15 | .07 | .10 |
| Total other income | .21 | .21 | .15 | .07 | 1.56 |
| Total income | 3.24 | 2.94 | 2.87 | 3.93 | 5.85 |
| Less: | |||||
| State income tax and declared | |||||
| value excess-profits taxes | .19 | .17 | .17 | .28 | .35 |
| Statutory excess profits net income | 3.05 | 2.77 | 2.70 | 3.65 | 5.50 |
| Abnormality adjustment | (.10) | (1.46) | |||
| Excess profits net income as | |||||
| adjusted | 3.05 | 2.67 | 2.70 | 3.65 | 4.04 |
In order to compete on more equal terms with the means of distribution employed by its two major competitors, *278 which included a system of branch warehouses operated throughout the country, petitioner opened a warehouse in San Francisco in August 1936, and a second in Marietta, Minnesota, in January 1938. In 1936 a similar arrangement was obtained in Cuba, not for competitive reasons but for the market openings available.
The mechanics of sales from the warehouses as contrasted to the direct sales from the plant at Shelby, North Carolina, were as follows: When an order was received at the plant, it was transcribed on an order form which was sent to the shipping department, where the order was assembled for shipment. Then the order form was returned to the office where an invoice was made up and addressed to the customer or consignee. The shipments made from the plant were generally individual orders and went by parcel post express. Orders from the warehouses were requisitioned by the warehouse management. These orders were usually sizable shipments to replace warehouse stocks and were shipped by the cheapest means of transportation, by rail or water, in carload shipments when possible. Salesmen operating in the territory of a warehouse would send their orders to the particular warehouse*279 for execution and although the invoices were *905 made to the warehouse at the time the order was filled, payment for the order was made at the plant at Shelby by the customers and it was from the plant that the salesmen derived their commissions. The manager of the warehouse would be compensated on a commission basis for the volume of business transacted through his warehouse, and from this remuneration he paid the expenses of his rental, labor, packing, and clerical help. Petitioner defrayed the expense of shipments to the warehouse for consignee or customer.
The procedure followed as regards the Cuban branch differed in several respects. Goods were shipped to the Cuban warehouse on a consignment basis. The sales agent in charge would handle all collections himself and would remit to petitioner an amount equaling his collections which corresponded to the invoices, copies of which were also forwarded to Shelby, less a commission allowed the Cuban agent for his services. The Cuban agent assumed all expenses other than the duties and cost of putting the goods in his warehouse. The sales agent in Cuba established his own selling prices for petitioner's products. He prepared*280 a price list based on what the market would bear and submitted these lists to petitioner for approval. The prices appearing on the Cuban price list averaged substantially higher than the comparable prices appearing on the list for the same item sold in the United States.
Dollar sales through the three principal warehouses grew rapidly from their inception to the end of the base period. Sales by years from the warehouses in California, Minnesota, and Cuba for the calendar years 1936 to 1939, inclusive, were as follows:
| 1936 | 1937 | 1938 | 1939 | |
| California | $ 3,880.47 | $ 26,824.91 | $ 55,962.43 | $ 77,646.37 |
| Minnesota | 93,112.24 | 137,013.91 | ||
| Cuba | 387.28 | 7,894.87 | 27,798.87 | 53,978.41 |
| $ 4,267.75 | $ 34,719.78 | $ 176,873.54 | $ 268,638.69 |
Summarized below are the monthly sales of each of petitioner's warehouse for the calendar years 1936 through 1939, inclusive, and for the fiscal years ended August 31, 1936 through 1939, inclusive:
| Dollar Sales Through Branches by Months | ||||
| 1936 | 1937 | 1938 | 1939 | |
| CALIFORNIA | ||||
| January | $ 1,593.33 | $ 3,910.93 | $ 6,514.66 | |
| February | 2,369.68 | 5,101.54 | 8,784.10 | |
| March | 3,129.22 | 4,948.08 | 11,203.76 | |
| April | 2,159.40 | 4,822.18 | 6,502.55 | |
| May | 1,868.93 | 4,879.06 | 4,807.25 | |
| June | 1,632.89 | 3,102.25 | 4,195.70 | |
| July | 2,054.10 | 3,245.91 | 4,216.50 | |
| August | $ 138.34 | 2,478.23 | 3,728.80 | 6,108.21 |
| Total FY 8/31 | $ 138.34 | $ 21,027.91 | $ 43,277.88 | $ 74,556.41 |
| September | $ 411.20 | $ 2,682.07 | $ 4,998.38 | $ 6,395.23 |
| October | 1,525.67 | 3,167.11 | 6,472.89 | 7,498.69 |
| November | 999.43 | 2,214.28 | 7,137.87 | 7,713.35 |
| December | 805.83 | 1,475.67 | 3,614.54 | 3,706.37 |
| Total calendar year | $ 3,880.47 | $ 26,824.91 | $ 55,962.43 | $ 77,646.37 |
| MINNESOTA | ||||
| January | $ 5,123.00 | $ 17,771.21 | ||
| February | 7,725.48 | 14,929.50 | ||
| March | 11,969.62 | 15,408.40 | ||
| April | 8,154.80 | 7,826.37 | ||
| May | 3,209.00 | 4,951.94 | ||
| June | 2,045.53 | 6,167.61 | ||
| July | 5,212.57 | 7,398.07 | ||
| August | 8,347.75 | 13,570.36 | ||
| Total FY 8/31 | $ 51,787.75 | $ 129,347.95 | ||
| September | $ 10,238.40 | $ 11,703.38 | ||
| October | 12,008.46 | 14,055.74 | ||
| November | 10,021.19 | 12,319.49 | ||
| December | 9,056.44 | 10,911.84 | ||
| Total calendar year | $ 93,112.24 | $ 137,013.91 | ||
| CUBA | ||||
| January | $ 220.31 | $ 1,583.48 | $ 3,012.45 | |
| February | 252.04 | 1,993.64 | 3,480.56 | |
| March | 342.17 | 2,420.42 | 4,811.55 | |
| April | 366.95 | 2,429.22 | 3,913.31 | |
| May | 469.25 | 2,151.61 | 2,935.98 | |
| June | 735.77 | 2,296.76 | 3,801.03 | |
| July | 965.73 | 1,937.02 | 4,174.29 | |
| August | 699.82 | 2,280.20 | 3,102.74 | |
| Total FY 8/31 | $ 4,439.32 | $ 20,935.18 | $ 39,938.43 | |
| September | $ 812.94 | $ 2,841.94 | $ 6,629.74 | |
| October | 987.20 | 2,608.76 | 7,592.81 | |
| November | $ 190.13 | 1,014.71 | 2,570.67 | 4,338.25 |
| December | 197.15 | 1,027.98 | 2,685.15 | 6,185.70 |
| Total calendar year | $ 387.28 | $ 7,894.87 | $ 27,798.87 | $ 53,978.41 |
*281 *906 The growth of sales from branch warehouses was a steady and rapid growth during the base period and had the petitioner put its warehouses into operation 2 years before it actually did, total sales through warehouses would have reached $ 1,464,699 for the 4-year period ended December 31, 1939. The total sales for the calendar year 1939 would have reached $ 612,523.
The petitioner's books of account reflect only the results of its overall operations. No departmentalized accounting system was maintained. Sales were not segregated by product nor were the sales by warehouses segregated. No allocation from costs or expenses by product or operations was made on petitioner's books of account; instead all expenses of the same nature were charged into a single account. No allocation was made of selling or general administrative expenses to the various products sold. Petitioner's books of account do not indicate a breakdown of the net profit realized on sales direct from the Shelby plant and the net profit earned on sales through *907 branch warehouses. It is impossible to make a conclusive segregation of net profit realized on the Shelby sales as distinguished from the*282 warehouse sales. On its over-all operations the petitioner realized a net profit of 3.78 per cent for the calendar year 1939.
In August 1939 the petitioner added to its business a boxed rug making yarn product and offered it for sale as Article No. 241. This product was intended and used for making pompom or fluff rugs at home. It had never been offered before by any company. The rug yarn ended the petitioner's search for a unique product which would sell in volume at a high profit not dictated by competition.
During the base period petitioner did not manufacture the yarn sold as Article No. 241. It was purchased packaged and boxed ready for resale from Cleveland Mills Company, which was the only supplier of this item to petitioner during the base period. A summary of petitioner's monthly purchases and sales of Article No. 241 during the period August through December 1939, is as follows:
| Boxes | ||
| Quantity | Quantity | |
| 1939 | purchased | sold |
| August | 2,776 5/12 | 153 |
| September | 529 | 794 |
| October | 954 | 1,954 |
| November | 3,034 | 4,010 |
| December | 3,117 | 1,218 |
Cleveland Mills Company was one of the petitioner's principal suppliers of finished products. The*283 petitioner was at all times one of Cleveland Mills Company's largest customers. Cleveland Mills supplied petitioner only on a competitive basis.
During 1939 Cleveland Mills charged the petitioner a price of $ 1.13 per box, 12 skeins to the box, 1 label to each skein, packed and ready for shipment. This price was subject to a 2 per cent discount for cash in 10 days. This price was computed on a cost plus basis and was sufficiently high to cover the experimental costs and risk inherent in a new product. Cleveland Mills followed the practice of pegging its price sufficiently high on small order experimental items to protect itself in case the product was later discontinued or lost to a competitor. Article No. 241 had a color range of 32 colors. The cost quoted by Cleveland Mills was based upon the cost involved in dyeing the deepest shades.
The petitioner offered Article No. 241 for sale at list price of $ 1.95 per box less 20 per cent trade discount, or a net price of $ 1.56. For the same period the petitioner's salesmen were paid commissions of 8 per cent on the item. J. W. Schenck and petitioner's sales manager decided to treat Article No. 241 as a permanent part of petitioner's*284 line, and in December 1939 it was decided to raise the net price per box to $ 1.60 and to lower the salesmen's commission rate to 6 per cent. *908 The broad acceptance of the product dictated these decisions. The growth in sales of Article No. 241 was unusually rapid during the few months of the base period during which it was marketed. The petitioner's competitors would normally enter a product in competition with Article No. 241 within 1 year, and an additional 6 months would be required to make competition effective. In view of the new and unique character of the item and the lack of effective competition, sales under normal conditions would have continued at a rapid rise in a wide market until competition slowed its sales growth approximately 18 months after its introduction. Competition would not have slowed growth to a normal extent because of the development of a cardboard form used in connection with Article No. 241 to produce a pompom or fluff effect. This form was given away during the base period. Later the principle was developed to the extent that it was more elaborately made in wood and patented.
The wholesale price of carded cotton yarn during the base period*285 is reflected in the following schedule:
| Carded cotton yarn: * Wholesale price | ||||
| per pound at Boston monthly, 1936-1939 | ||||
| Month | 1936 | 1937 | 1938 | 1939 |
| Cents | ||||
| January | 41.5 | 46.3 | 33.3 | 30.3 |
| February | 41.5 | 43.5 | 33.3 | 30.3 |
| March | 39.3 | 43.5 | 33.3 | 30.3 |
| April | 38.5 | 44.3 | 33.3 | 30.3 |
| May | 38.5 | 43.3 | 33.3 | 30.3 |
| June | 37.3 | 40.8 | 31.4 | 30.3 |
| July | 38.5 | 39.7 | 30.5 | 31.3 |
| August | 38.8 | 37.3 | 30.3 | 31.5 |
| September | 40.1 | 36.8 | 30.3 | 35.1 |
| October | 40.5 | 34.6 | 30.4 | 36.5 |
| November | 40.8 | 33.3 | 30.8 | 37.8 |
| December | 43.6 | 33.3 | 30.5 | 37.8 |
| Average | 39.9 | 39.8 | 31.7 | 32.7 |
The price trend reflected in the above figures, which are taken from the Boston market, existed in other domestic cotton markets during the same period.
Had the petitioner introduced Article No. 241 2 years prior to the date on which it was originally introduced, a sales volume of 372,000 boxes would have been reached by the end of 1939. On the same assumption the selling price would have been $ 2 per box less a 20 per cent trade discount, and a net selling price of $ 1.60 per box, and *286 petitioner would have realized a profit percentage of 16.33 per box.
The petitioner's sales from the Shelby office, designated herein as normal sales, increased in volume during each year of the base period and in 1939 the petitioner reached a new and enduring level of earnings from this source, which was attributable to the establishment of the petitioner's own sales office, sales force, and the practice of *909 advertising on a national basis. These changes were instituted immediately prior to the base period.
The following schedule sets forth in round figures the petitioner's normal sales, warehouse sales, and sales of Article No. 241 for each of the calendar years of the base period:
| Normal | Warehouse | Article No. | ||
| Calendar year | sales | sales | 241 sales | Total |
| 1936 | $ 1,118,000 | $ 4,000 | $ 1,122,000 | |
| 1937 | 1,106,000 | 34,000 | 1,140,000 | |
| 1938 | 1,366,000 | 176,000 | 1,542,000 | |
| 1939 | 1,435,000 | 268,638 | $ 12,000 | 1,715,000 |
The excess profits tax of the petitioner computed under the relief granted by the respondent is excessive and discriminatory. The sum of $ 151,948 is a fair and just amount representing normal earnings to be used as a constructive average base*287 period net income for each of the years involved, except the fiscal years ended August 31, 1941 and 1942, which do not represent a full year's operations at the level that the petitioner would have attained had the changes in character here involved been made 2 years sooner. For the fiscal years ended August 31, 1941 and 1942, $ 116,088 and $ 132,742, respectively, represent fair and just amounts of normal earnings to be used as a constructive average base period net income. In accordance with section 711 (b) (1) (A) for the fiscal year ended August 31, 1941, the constructive average base period net income for that year is to be reduced by the amount of the petitioner's income tax for said year.
OPINION.
The principal question in issue here is whether the petitioner is entitled under the provisions of section 722 (b) (4)1 to *910 a greater average base period net income and consequently a greater excess profits credit for the years involved than that allowed by the respondent.
*288 The petitioner contends, and the respondent agrees, that the petitioner is entitled to relief under section 722 (b) (4) by reason of the changes in character of its business brought about by the introduction of Article No. 241, a new product, and the establishment of three branch warehouses for the distribution of petitioner's products during the base period.
The petitioner has undertaken to establish by several computations that its constructive average base period net income should be $ 220,949. However, we are unable to accept the petitioner's reconstruction for the reason that the evidence considered as a whole fails to support the assumptions on which the petitioner's reconstructed average base period net income is based. For example, the index used by the petitioner to backcast warehouse and Article No. 241 sales had little or no relation to the business of the petitioner and could not be accepted for the purpose for which it was used. In addition to this, the petitioner's method of using both a sales and an earnings index is objectionable, particularly in the instant case where the two indexes relied upon are so contradictory as to cancel each other in application.
It would*289 serve no purpose to attempt to discuss each separate item of petitioner's reconstruction nor the methods used to substantiate its figures for sales and expenses. The proposed computations, which are optimistic in the extreme, involved various business indexes, mathematical and statistical formulae, and the testimony of expert witnesses. Likewise, it would be futile to attempt to reconcile the respondent's position herein with the reconstructed average base period net income contended for by the petitioner or for that matter with the amount actually allowed the petitioner by the respondent. Suffice it to say, that the respondent's many arguments have been considered and accorded the weight to which their respective validity entitles them.
We have undertaken to evaluate the evidence and the arguments presented by the parties and to apply the relief provisions before us as fairly and accurately as possible. To our satisfaction the record herein does establish a proper basis for reconstruction. Our own appraisal of the facts and the testimony of the parties herein has led *911 us to a sum which, in our judgment, is a fair and just amount to be used as a constructive average *290 base period net income for the petitioner. The purpose of the 2-year push-back rule is to establish a figure assumed to be the level of earnings which would have been reached by the petitioner in its last base period year if the changes in character entitling it to relief had occurred 2 years before they actually did. We have used the assumed figure as a point of departure and backcast the 1939 earnings of the petitioner through the base period years, using as a relative criterion the business statistics placed in the record by the parties. Our Findings of Fact fully set forth the various factors considered.
When, as here, the evidence and record fail to support the computations submitted by both parties as a reconstructed average base period net income, this Court may, after an examination of all the evidence, proceed to a reconstruction which is supported by the facts. Superior Valve & Fittings Co., 18 T. C. 931; Radio Shack Corporation, 19 T. C. 756. In doing this we recognize that section 722 of the Code does not prescribe an exact criterion for reconstruction and that a reconstruction must, to some extent, be based*291 upon hypothesis and conjecture, and approximation, in short, where an absolute is not only not available but impossible of determination. The record as a whole supports to our satisfaction the finding that the sum of $ 151,948 is a fair and just amount to be used as a constructive average base period net income for the petitioner.
The record also establishes and we have found as a fact that at the end of 1939 the business of the petitioner, after application of the 2-year push-back rule, was still in a state of continued growth and had not reached a normal level of sales and earnings. We, therefore, sustain the respondent in his determination that the variable credit rule is properly applicable to this case and hold, in accordance with our findings of fact, that $ 116,088 for the fiscal year ended August 31, 1941, and $ 132,742 for the fiscal year ended August 31, 1942, are fair and just amounts representing normal earnings to be used as the petitioner's constructive average base period net income for those years.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
*. Southern, 40's single, carded.
Source: Supplement to Survey of Current Business, 1940, page 155, and 1942, page 167.↩
1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
(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 --
* * * *
(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, * * *↩