*174 Decision will be entered for the respondent.
Excess Profits Tax Relief -- Changes Under Sec. 722 (b) (4). -- Excess profits tax relief denied where evidence does not show that changes from manufacturing and selling weaving yarns to knitting yarns, if made 2 years earlier than they were, would have resulted in an increase in base period earnings sufficient to produce excess profits credits greater than those available to petitioner under the invested capital method.
*373 The Commissioner has disallowed the petitioner's claims for excess profits tax relief for the years 1943, 1944, and 1945. The petitioner contends that it qualifies for relief*175 under section 722 (b) (4) by reason of a change, immediately prior to the base period, from manufacturing weaving yarns to manufacturing knitting yarns.
FINDINGS OF FACT.
The petitioner filed its corporate tax returns for the years involved with the collector of internal revenue for the district of Maine.
The petitioner is engaged in the business of spinning worsted yarns. It was incorporated under the laws of Maine in 1906. Its stock is all held by members of the Jagger family. The business had been operated for a number of years previously by a partnership composed of Samuel B. Jagger and a brother. The petitioner was equipped, until about 1928, to manufacture low grades of wool and mohair yarn used, principally, for upholstery and different types of weaving. It did not purchase the wool or mohair stock on its own account but did the spinning for textile mills on a commission basis.
Its principal customer, until about 1923 or 1924, was Sanford Mills of Sanford, Maine. Sanford Mills established its own spinning mill at about that time and terminated its relationship with the petitioner. The latter undertook to find other business but was not too successful. It continued to*176 do some commission spinning and also purchased wool and manufactured yarn which it sold to the trade. However, the business was unprofitable on that basis of operation. Operating losses of from about $ 2,000 to $ 5,000 were sustained in each year over the period 1928 to 1932, inclusive.
The petitioner began to improve and modernize its plant beginning in 1928. Its equipment, for the most part, was old and outmoded. One of the changes made was to begin replacing its old "flyer" type *374 spindles with new type "cap" spindles. The new spindles could be used either for spinning or knitting. The petitioner also put in 14 spinning frames, which it purchased second hand, and other equipment. The spinning frames were acquired in 1931. Improvements were also made in some of the other equipment and plant arrangement. The petitioner's machinery and equipment account increased from approximately $ 54,000 to approximately $ 80,800 over the period 1928 to 1932.
A selling agent, whom the petitioner had consulted, advised it in 1933 to change over to the knitting yarn business as soon as possible. He proposed to offer the knitting yarns manufactured by the petitioner on the Philadelphia*177 and New York markets.
Knitting yarns and weaving yarns are manufactured and handled by separate branches of the industry. Knitting yarn is softer and has less twist than weaving yarn. The two yarns require different types of wool, or other materials, and have different uses. Weaving yarns are used in making cloth goods, such as men's suitings and like materials, while knitting yarns are used chiefly for sweaters and articles of that type. Knitting yarns can be manufactured more rapidly and at less cost than weaving yarns.
The petitioner began manufacturing knitting yarns on a small scale in 1933. The following table shows its sales of yarns in pounds sold (for the years 1933 to 1943, inclusive) and in dollars (for the years 1933 to 1939, inclusive) divided as between weaving and knitting yarns, and also as between commissions work and own wools:
| Pounds | ||||||
| Year | Weaving yarns | Knitting yarns | ||||
| Commission | Own wool | Total | Commission | Own wool | Total | |
| 1933 | 109,396 | 109,396 | 4,102 | 4,102 | ||
| 1934 | 28,480 | 28,480 | 111 | 111 | ||
| 1935 | 30,885 | 30,885 | 72,447 | 18,072 | 90,519 | |
| 1936 | 60,976 | 60,976 | 75,993 | 1,793 | 77,786 | |
| 1937 | 1,813 | 58,515 | 60,328 | 60,788 | 96,481 | 157,269 |
| 1938 | 2,731 | 14,841 | 17,572 | 62,902 | 253,886 | 316,788 |
| 1939 | 14,673 | 2,684 | 17,357 | 26,888 | 327,419 | 354,307 |
| 1940 | 16,745 | 4,581 | 21,326 | 16,801 | 267,398 | 284,199 |
| 1941 | 5,101 | 32,911 | 38,012 | 41,501 | 374,487 | 415,988 |
| 1942 | 32,523 | 22,891 | 55,414 | 15,502 | 306,820 | 322,322 |
| 1943 | 54,214 | 54,214 | 349,440 | 349,440 |
| Dollars | ||||||
| Year | Weaving yarns | Knitting yarns | ||||
| Commission | Own wool | Total | Commission | Own wool | Total | |
| 1933 | $ 129,791.42 | $ 129,791.42 | $ 3,265.91 | $ 3,265.91 | ||
| 1934 | 39,537.43 | 39,537.43 | 125.16 | 125.16 | ||
| 1935 | 42,521.17 | 42,521.17 | $ 12,198.20 | 19,065.25 | 31,263.45 | |
| 1936 | 82,944.79 | 82,944.79 | 13,730.67 | 1,973.14 | 15,703.81 | |
| 1937 | $ 731.59 | 90,044.24 | 90,775.83 | 12,152.38 | 129,193.81 | 141,346.19 |
| 1938 | 919.14 | 18,224.45 | 19,143.59 | 12,430.74 | 279,839.78 | 292,270.52 |
| 1939 | 5,723.60 | 3,158.55 | 8,882.15 | 6,298.96 | 388,945.13 | 395,244.09 |
*375 The petitioner had to overcome numerous difficulties and was handicapped by lack of capital in changing over from weaving yarns to knitting yarns. It also experienced difficulties in establishing a market for its knitting yarns. This was a highly competitive field and the petitioner lacked the necessary contacts with the industry. The output capacity of the industry generally exceeded the demand for all types of woolen goods. Most of the mills in the United States operated at or below their capacity for a single-shift operation during the base period.
The petitioner did not operate its mill on more than a*179 single-shift, 40-hour-a-week basis, during the entire base period. It had attained an output capacity of between 600,000 and 700,000 yards of knitting yarns per year by the end of 1939, but it did not reach that capacity during any year prior to 1945.
The petitioner's officers were not paid salaries, as officers, during the period 1934 through 1939, but received compensation on a weekly basis in the form of wages. The officers, in 1939, were Samuel B. Jagger, president, Winston Jagger, vice president, and Allan Jagger, treasurer. Robert Jagger was carried on the payroll as clerk. They each received $ 20 a week compensation. The petitioner's total salaries and wages for 1939 were as follows:
| Direct labor | $ 43,499.46 |
| Indirect labor | 3,763.30 |
| Compensation of officers | 4,360.00 |
| Selling expense | 8,280.32 |
| Factoring | 5,158.20 |
| Total | $ 65,061.28 |
The petitioner's net income or losses for the years 1922 to 1945, inclusive, as reported in its returns for those years, compared with the net income or losses of all woolen and worsted textile corporations in the United States (for the years 1922-1939, inclusive) are shown in the following schedule:
| All worsted and | ||
| woolen textile | ||
| corporations | ||
| Year | Net income | (thousands) |
| 1922 | $ 4,486.53 | $ 56,158 |
| 1923 | 1,151.68 | 60,453 |
| 1924 | (1,530.55) | 17,596 |
| 1925 | 4,140.74 | |
| 1926 | (8,714.85) | 1,233 |
| 1927 | 390.35 | 8,730 |
| 1928 | (5,167.74) | (1,079) |
| 1929 | (5,187.18) | (10,294) |
| 1930 | (4,614.26) | (35,326) |
| 1931 | (2,799.84) | (31,243) |
| 1932 | (3,838.98) | (37,191) |
| 1933 | (1,911.29) | 19,424 |
| 1934 | ($ 9,918.89) | ($ 12,169) |
| 1935 | (6,671.80) | 19,497 |
| 1936 | 91.29 | 22,829 |
| 1937 | (6,202.85) | (1,694) |
| 1938 | 79.68 | (13,806) |
| 1939 | 34.11 | 25,661 |
| 1940 | (2,047.63) | |
| 1941 | 148.64 | |
| 1942 | 4,926.40 | |
| 1943 | 24,807.59 | |
| 1944 | 53,347.67 | |
| 1945 | 56,850.61 |
*180 *376 The petitioner's excess profits tax credit computed on the invested capital basis, and its excess profits tax liability, as determined by the Commissioner, for the taxable years 1943, 1944, and 1945, are as follows:
| Excess profits | Excess profits | |
| Year | tax credit | tax liability |
| 1943 | $ 2,530.82 | $ 17,048.71 |
| 1944 | 3,930.62 | 33,717.21 |
| 1945 | 5,644.98 | 36,575.20 |
The petitioner timely filed applications for excess profits tax relief and claims for refund for each of the years 1943, 1944, and 1945, in the respective amounts of $ 16,138.10, $ 27,847.42, and $ 12,770.85. The claims were disallowed in full by the Commissioner.
All stipulated facts are incorporated herein by this reference.
OPINION.
The petitioner's contention is that it qualifies for excess profits tax relief under section 722 (b) (4) by reason of the fact that it changed the character of its business immediately prior to the base period by changing its product from weaving yarns to knitting yarns. It alleges that there was not only a change in product but a change in its marketing and management. It also alleges, apparently to support its claim under section 722 (b) (2), that the Commissioner erred*181 in finding that "price cutting was not unusual." However, it has offered no evidence and has made no argument on brief as to any change in management or as to any price cutting, and we will, therefore, assume that those issues, if properly raised, have been abandoned.
The Commissioner does not seriously dispute that the change from weaving yarn to knitting yarn was of such nature as to constitute a change in the character of the business within the meaning of section 722 (b) (4), but contends that the change was not "immediately prior to the base period" since it was made in 1933; the change did not result in increased earnings and is, therefore, not a qualifying change under the statute; the petitioner's base period earnings are not an inadequate standard of normal earnings; and, finally, the petitioner has failed to establish what would be a fair and just amount representing normal earnings to be used as a constructive base period earning. Regulations 112, section 35.722-3 (d), is to the effect that no temporal limitation can be placed upon the term "immediately prior to the base period" for the purpose of section 722 (b) (4). Morgan Construction Co., 23 T. C. 242.
*182 The petitioner began making the changeover to knitting yarns in 1933 but it was not until 1935 that it had a sufficiently large production to complete the necessary adjustments for the change or to establish *377 a market for its knitting yarns. Approximately 4,000 pounds of knitting yarn were produced in 1933, 111 pounds in 1934, and 90,519 pounds in 1935. The change to knitting yarns may be considered as having taken place immediately prior to the base period. Morgan Construction Co., supra.
A more serious question is, what effect the change had on the petitioner's earnings. The petitioner, in a reconstruction of base period earnings, would be entitled only to such increased earnings as might reasonably be attributed to the change. The petitioner's situation showed improvement by the close of the base period, after at least 4 years of development under the change, but it was barely breaking even. It had losses of over $ 6,000 in 1935 and 1937, and income of only $ 91.29 in 1936, $ 79.68 in 1938, and $ 34.11 in 1939. Even if we look to later results, the petitioner's case is no better. There was a further loss of $ 2,047.63 in 1940 and *183 only $ 148.64 of income in 1941, the sixth year after the change to knitting yarns. It was not until the war economy years of 1942, 1943, and 1944 that the petitioner had any substantial profits. The evidence is that in 1942 and 1943 most of the production of wool yarn was on Government orders. The woolen industry was in a highly competitive state throughout, and some time prior to, the base period, and most woolen yarn manufacturers were operating at below capacity. The industry as a whole suffered net losses in every year from 1927 to 1935, except for 1933. The petitioner had an average yearly net loss of approximately $ 6,000 for the base period, yet its base period average was its best for any 4-year period since 1923. It had sustained net losses ranging from approximately $ 2,800 to nearly $ 10,000 in every year since 1927.
The present record does not justify a finding that if all of the changes relied upon by the petitioner had taken place 2 years earlier than they actually did, the petitioner would have had an average base period net income sufficient to produce excess profits credits greater than those allowed it under the invested capital method.
Reviewed by the Special*184 Division.
Decision will be entered for the respondent.