Southern California Edison Co. v. Commissioner

Southern California Edison Company Ltd., Petitioner, v. Commissioner of Internal Revenue, Respondent. Southern California Edison Company (Formerly Southern California Edison Company Ltd.), Petitioner, v. Commissioner of Internal Revenue, Respondent

Southern California Edison Co. v. Commissioner

Docket Nos. 6903, 38498, 38499

United States Tax Court

19 T.C. 935; 1953 U.S. Tax Ct. LEXIS 231;

March 4, 1953, Promulgated

---

Decisions will be entered under Rule 50.

1. In connection with the construction of Boulder Dam petitioner in 1930 contracted to purchase certain minimum specified amounts of electric power to be generated for a period of about 50 years. As the facts developed it was not required to begin taking such power pursuant to its commitment prior to June 1, 1940. The dam was completed and some generating facilities actually began to produce electric energy in 1936. In late 1936 and early 1937, three cities, Los Angeles, Burbank, and Glendale, which had previously purchased their power at wholesale from petitioner for resale through their municipally owned distribution systems, began to buy their power at Boulder. Petitioner did not replace the load which it thus lost until the middle of 1939. Held, petitioner has qualified for relief under section 722(b)(2). However, correction of the abnormality is subject to certain limitations which must be observed.

2. By reason of its own commitment to take Boulder power, petitioner claimed relief under section 722(b)(4). Held, any such relief must be based upon the earnings that petitioner would have realized or upon the level of earnings that it would have attained by the end of the base period within the framework of (b)(4), upon the assumption that the increased capacity were available to it at that time; relief cannot be allowed upon the strength of "normal earnings" that might be realized in the post-1939 years merely because they might have been foreseeable in the future as of the end of 1939. Even though evidence of post-1939 events may to a limited extent be taken into account in commitment cases, the statute contemplates that the correction of any abnormality arising from the commitment must be made within the framework of the base period itself.

3. Held, that apart from the possible loss of one unusually large sale of power based upon 100,000-kilowatt capacity, petitioner's sales did not in fact suffer during the base period by reason of any lack or potential lack of productive capacity; the availability during the base period of the Boulder power for which petitioner had committed itself would not have resulted in increased earnings. Correction approved to some extent for the profit that might have been realized on the 100,000-kilowatt sale.

4. In applying the (b)(4) push-back rule, ordinarily only the qualifying factor is pushed back, and it is superimposed upon economic and other conditions as they actually existed during the base period. However, in exceptional situations where certain conditions are inextricably intertwined with the qualifying factor the push-back rule may operate on those conditions as well. Held, in the circumstances of this case, petitioner's commitment for Boulder power was such an integral part of the Boulder project, that the project itself is subject to the push-back rule as well as petitioner's commitment. Extent to which petitioner has proved that it is in fact entitled to relief in this connection considered.

5. Certain abnormalities relating to interest and depreciation deductions may be corrected in a reconstruction, pursuant to E.P.C. 6, and it is therefore unnecessary to determine whether they would otherwise qualify for relief under section 722(b)(5).

6. Petitioner's average base period net income was determined by use of the growth formula in section 713 (f), and it thus automatically had the advantage of a considerable amount of relief. The corrections permitted by section 722 must not duplicate any of the corrections that are already reflected in the use of the growth formula. Relief is allowable only to the extent that the constructive average base period net income, computed without regard to the growth formula, exceeds the average base period net income otherwise determined without reference to section 722.

A. Calder Mackay, Esq., William L. Kumler, Esq., and Adam Y. Bennion, Esq., for the petitioner.

R. E. Maiden, Jr., Esq., and Raymond B. Sullivan, Esq., for the respondent.

Raum, Judge.

---

RAUM

In these three proceedings, consolidated for trial, the Commissioner denied applications for relief under section 722, I. R. C., pertaining to the years 1942, 1943, 1944, and 1945. In Docket No. 6903, he also determined a deficiency of $ 35,533.53 in income tax for 1941, an overassessment of $ 778,158.87 in income tax for 1942, and a deficiency of $ 1,681,572.16 in excess profits tax for 1942.

By stipulation the parties have settled many of the issues raised by the pleadings, leaving primarily to be decided petitioner's right to relief under section 722.

FINDINGS OF FACT.

The parties have entered into various stipulations of fact, and a number of joint exhibits have been introduced in evidence in lieu of being incorporated in the stipulations. The stipulations are hereby adopted as part of our findings and are incorporated herein by reference together with the joint exhibits.

Petitioner in each of these proceedings is, and since 1909 has been, a corporation organized under the laws of theState of California. Its principal place of business is located at Los Angeles, California. Its stock is widely held. For the years in issue, petitioner filed its Federal tax returns with the collector of internal revenue for the sixth district of California.

Petitioner is an operating public utility engaged in the business of generating, transmitting, distributing, and selling electric energy for light, power, and heat to domestic, commercial, industrial, agricultural, and municipal consumers and other utilities in the central and southern portions of the State of California. It provides electric service within a territory of approximately 17,500 square miles, measured by the area of the judicial townships in which service is rendered, including 75 incorporated cities, more than 240 unincorporated communities, and the outlying rural territory. Petitioner is also engaged, incidentally, in the operation of a small oil field located on its utility properties; its gross revenues in 1939 from this enterprise were slightly over 1 per cent of its gross revenues from electric operations. Petitioner owns and operates electric property serving Los Angeles County (except the cities of Los Angeles, Pasadena, Glendale, Burbank, and Azusa), Ventura County, and portions of Orange, Riverside, San Bernardino, Santa Barbara, Tulare, Kern, and Kings Counties. Petitioner's territory covers a portion of the citrus fruit-growing and agricultural region of southern California, where electricity is used for pumping irrigation water and for refrigeration.

Petitioner is subject to regulation by the California Public Utilities Commission, referred to herein as the "Utilities Commission," and formerly known as the California Railroad Commission.

Petitioner's Production Resources.

Petitioner's system for generating electricity involves the use of both "hydro" and steam facilities: that is, it has hydro plants, which utilize water power to run the generators, and it has steam plants, which depend upon fuel for that purpose. During and prior to the base period, its hydro plants were of two kinds: stream-flow plants and reservoir-supported plants. (1) There were 19 stream-flow plants during the base period, with 47 generators, having a total "rated" or "installed" operating capacity of approximately 92,000 kilowatts. ¹ Of these the three largest plants, with a rated capacity of 66,500 kilowatts, were located on the Kern River, north of Los Angeles; the other 16 stream-flow plants were small, ranging in rated capacity from 200 to 4,000 kilowatts. (2) There were five reservoir-supported plants, known as the "Big Creek plants," containing 15 generators with a rated operating capacity of approximately 397,000 kilowatts, located in the Sierra Mountains approximately 260 miles north of Los Angeles.

Supplementing its hydro plants, petitioner had three steam plants during the base period. The three steam plants (at which 11 generators were installed) were located at Long Beach, California, and had a total rated capacity of about 415,000 kilowatts. In addition, petitioner had a diesel plant (with five generators) at Vernon City, California, with a rated generating capacity of 24,250 kilowatts.

During the base period, the rated productive capacity of petitioner's plants thus totaled about 930,000 kilowatts. At the beginning of 1937, one steam plant, with a rated capacity of about 60,000 kilowatts, was leased by petitioner to the City of Los Angeles, leaving petitioner with a rated capacity of about 870,000 kilowatts.

Petitioner's plants, both hydro and steam, were subject to "outages," when production from particular plants either declined or stopped completely. Such outages might be scheduled, as when units were "taken off the line" for annual overhaul or routine maintenance, or they might be unscheduled or "forced," resulting from actual or imminent breakdown in equipment or from other "trouble."

Because of these outages, and also because of adverse water conditions affecting the operation of the hydro plants, petitioner's "effective" productive capacity, representing the maximum power petitioner could deliver at a particular time, might be less than its "rated" or "installed" capacity. Petitioner also lost power over its lines in the course of transmission and distribution.

Production from stream-flow plants depended upon the volume of water running in the streams, which in turn was dependent on precipitation and run-off conditions in the watershed supplying the streams. Those plants were in operation at all times, except during outages, because the water flowing down the streams, unless used, was lost forever for generating purposes. Furthermore, there was no added cost in running water through a plant.

During the months of maximum run-off (usually the months of April, May, and June), when the maximum water comes down the streams, the plants generated at their rated capacity of approximately 92,000 kilowatts. But as the water diminishes in the streams after those months in each year, there is a reduction in the capacity of those plants, with the result that it might drop to between 30,000 and 40,000 kilowatts in an average water year, and as low as 19,000 kilowatts in a dry year.

Continuous operation of the stream-flow plants at the rated capacity of 92,000 kilowatts would theoretically result in a production of approximately 806,000,000 kilowatt-hours of electricity during a year (92,000 kilowatts multiplied by 8,760, the number of hours in a year). However, due primarily to dependence upon the available water, the production per year which petitioner was able to obtain from its stream-flow plants in the 10 years from 1930 through 1939 varied from a low of 352,000,000 kilowatt-hours in 1931, which was the second driest year in petitioner's history, to a high of 648,000,000 kilowatt-hours. The average production of the stream-flow plants in the 10 years from 1930 to 1939 was 524,000,000 kilowatt-hours; the 30-year average production, ending with the year 1935, was 573,000,000 kilowatt-hours; the average production during the base period, 1936-1939, was 596,470,326 kilowatt-hours; and production for 1939 was 551,929,058 kilowatt-hours. The following table shows production of the stream-flow plants, in millions of kilowatt-hours, for the 10 years, 1930-1939:

											10-year
Month	1930	1931	1932	1933	1934	1935	1936	1937	1938	1939	average
January	23	26	41	33	41	34	33	40	49	47	37
February	32	29	52	39	36	42	50	49	55	46	43
March	52	36	66	57	52	50	62	61	56	59	55
April	62	47	66	64	58	63	62	54	50	65	59
May	66	61	67	64	60	64	61	65	53	65	63
June	61	46	62	61	42	63	62	65	59	63	58
July	47	21	63	61	26	61	61	67	64	49	52
August	26	15	53	39	18	40	52	56	66	38	40
September	18	14	32	23	16	29	31	40	54	29	29
October	19	14	32	24	16	28	32	38	50	36	29
November	22	16	26	23	23	27	31	35	45	28	28
December	21	27	28	33	29	28	34	45	46	27	32
1 Total	449	352	587	521	417	528	571	615	648	552	524

Production from the reservoir plants similarly depends on water conditions. Water from streams is diverted into reservoirs in a mountain area, and the stored water is used to provide power for production of electricity. During the run-off season each year, in the months of April to July, the reservoirs are filled with most of the water used during the year for production of power at those plants. The water available at about the end of July has to be "stretched out" until the next run-off season. After the run-off season, the water is released from the reservoir in quantities and at times considered appropriate to obtain the most effective addition to the power provided through the stream-flow plants; thus, reservoir water is released in order to meet the daily "peak demands" described hereinafter. During the run-off season, reservoir plants might be used to a high degree in order to avoid spilling and wasting of water. The volume of water available for production of electricity in any one year might be increased to some extent by carrying over additional water from a prior year, thus reducing the water used for productive purposes in the prior year, or by reducing the quantity of water normally carried over to the subsequent year, thus decreasing the water available for production in the later year. The extent to which water could be stored in the reservoirs was also limited during the base years by the rights of downstream users.

Continuous operation of the reservoir plants at the rated capacity of 397,000 kilowatts would result theoretically in a production of 3,477,720,000 kilowatt-hours of electricity during a year. In a dry year such as 1931, the second driest year in petitioner's history, available water limited production from the Big Creek plants to 1,060,000,000 kilowatt-hours. During a good water year, such as 1938, petitioner generated 2,316,000,000 kilowatt-hours of electrical energy at its Big Creek plants. The 30-year average production from these plants was approximately 2,250,000,000 kilowatt-hours; average production at these plants during the base period was 2,267,860,950 kilowatt-hours; production for 1939 was 1,916,236,256 kilowatt-hours.

The following table shows the acre-feet of water in storage in the Big Creek reservoirs at the end of each month during the 10-year period, 1930-1939:

Month	1930	1931	1932	1933	1934
January	37,944	23,475	14,766	70,862	58,537
February	34,751	16,736	13,036	47,527	35,037
March	43,174	14,466	18,380	31,367	41,245
April	87,447	23,453	48,103	52,361	80,220
May	163,395	90,403	175,283	103,866	118,722
June	249,836	92,590	280,024	247,008	115,999
July	213,177	56,121	289,004	268,313	81,711
August	151,798	29,505	255,081	217,454	50,086
September	108,581	27,736	206,976	163,294	35,913
October	76,226	23,771	158,373	136,338	30,373
November	58,045	20,594	133,263	117,117	28,410
December	40,267	22,231	103,356	87,560	13,663

						10-year
Month	1935	1936	1937	1938	1939	average
January	10,241	38,358	25,582	52,553	106,298	43,862
February	4,726	34,291	18,187	46,923	83,702	33,492
March	5,339	24,451	9,164	60,617	77,376	32,558
April	51,418	77,775	42,129	63,611	139,373	66,589
May	172,956	214,744	229,299	173,805	209,083	165,156
June	289,063	288,002	264,949	266,005	221,823	231,530
July	280,391	287,663	265,226	287,297	188,161	221,706
August	233,589	242,820	217,381	282,316	144,935	182,497
September	182,954	181,320	161,716	248,143	113,617	143,025
October	130,626	138,928	110,680	212,232	101,667	111,921
November	87,703	96,388	70,396	176,457	77,114	86,549
December	56,164	61,839	75,839	138,901	58,492	65,831

The following table shows the actual production of the Big Creek plants, in millions of kilowatt-hours, each month for the 10-year period, 1930-1939:

Month	1930	1931	1932	1933	1934	1935
January	74	93	94	165	169	76
February	58	57	112	130	154	106
March	71	66	151	141	145	107
April	85	140	179	142	159	171
May	77	98	183	135	168	199
June	117	127	198	140	164	224
July	246	188	210	194	199	239
August	256	152	218	234	167	253
September	179	30	207	218	84	223
October	150	32	205	126	44	224
November	97	31	117	97	45	196
December	88	44	138	172	105	154
n1Totals	1,497	1,060	2,012	1,893	1,602	2,171

					10-year
Month	1936	1937	1938	1939	average
January	125	183	168	173	132
February	137	159	144	147	120
March	196	167	164	157	137
April	204	177	179	131	157
May	237	200	197	156	165
June	246	219	202	202	184
July	266	241	229	234	225
August	265	244	234	228	225
September	252	230	220	161	180
October	191	213	207	110	150
November	191	168	190	124	126
December	191	136	183	92	130
1 Total	2,500	2,340	2,316	1,916	1,931

Petitioner's hydro units, stream-flow and reservoir, were not sufficient to generate the number of kilowatt-hours needed in the course of its operations. The following table indicates the gap between petitioner's requirements and production from its hydro plants:

		Production of
	Total	petitioner's
Year	kilowatt-hours	hydro plants (in
	1 transmitted	kilowatt-hours)
1930	3,168,973,397	1,945,966,871
1931	3,061,836,977	1,411,787,300
1932	2,856,602,851	2,599,619,254
1933	2,772,640,491	2,413,776,170
1934	2,917,592,590	2,019,204,745
1935	3,139,306,603	2,698,684,688
1936	3,492,531,808	3,070,309,258
1937	3,138,653,552	2,954,850,677
1938	3,058,174,415	2,963,999,856
1939	3,622,973,103	2,468,165,514

Petitioner's steam plants were used in meeting its requirements to the extent that they were left unsatisfied by its hydro plants. Where there are both stream-flow and steam plants, it is to be expected that the stream-flow units will be utilized each year to the extent of the water available in the streams. The reservoir units will also be used in preference to steam if sufficient water is available, having due regard to the prospective as well as immediate need for water. The hydro plant must be maintained whether it is used or not, and there is no added cost in running water through the plant; production by steam, on the other hand, entails a considerable cost for fuel in order to operate the plant. The steam plants normally were used more extensively during the fall and winter months when, because of water limitations, the hydro plants could be operated at full capacity only for short periods each day. The steam plants also were used in meeting daily "peak demands," described hereinafter, and in providing "reserves," also described hereinafter.

Production at the steam plants, in millions of kilowatt-hours, was as follows:

Month	1930	1931	1932	1933	1934	1935
January	144	115	72	4	4	103
February	126	114	28	1	4	48
March	114	154	3	4	30	66
April	109	80	4	21	31	2
May	101	97	3	32	38	1
June	100	101	3	42	50	2
July	35	105	2	21	65	9
August	42	129	2	7	101	18
September	83	211	6	7	156	32
October	102	217	5	92	174	27
November	120	173	76	100	139	34
December	129	138	41	16	82	78
1 Totals	1,204	1,633	245	347	874	419

					10-year
Month	1936	1937	1938	1939	average
January	100	12	4	5	56
February	46	4	4	9	38
March	4	2	3	18	40
April	2	2	2	38	29
May	6	2	3	56	34
June	16	5	12	64	40
July	32	15	8	35	33
August	39	20	11	56	43
September	45	14	9	84	65
October	80	12	5	69	78
November	17	33	6	55	75
December	16	48	10	71	63
1 Totals	405	168	75	561	593

The Demand on Petitioner's System.

Petitioner operates under franchises, and is obligated to guard against power shortages and curtailment of service to customers within its franchise areas. Such a shortage and curtailment may have a widespread and detrimental effect, both on the utility and on its customers.

There were two types of shortages which petitioner, with its varying water supply, constantly had to guard against: (a) It had to have sufficient generating capacity, in kilowatts, to meet the maximum simultaneous or instantaneous demands of its customers, known as the "peak demands" and more fully described hereinafter; and (b) it had to have sufficient capacity to generate the quantity of kilowatt-hours of energy required by its customers throughout the year. In view of the water conditions on which petitioner was dependent, it was possible at certain times for it to have sufficient kilowatt capacity to meet peak demands, but to have insufficient water to generate kilowatt-hours in the volume necessary to meet customers' energy requirements throughout the year. ²

The greatest water shortage encountered by petitioner in its history was in 1924, when an insufficient water supply produced a power shortage which resulted in the appointment by the Utilities Commission of a power commissioner to enforce a mandatory program of rationing of power. Reductions in service were ordered, and applications for service were closely supervised. More recently, petitioner experienced a dry year in 1948; at that time measures were taken by the state to deal with the resulting power shortage. Experience indicated that in circumstances of exceptional water shortage "the industry would have gotten by somehow and undoubtedly would have had the assistance of the Commission * * * in formulating rules to serve everybody they could with the power available."

In addition to the problems raised by the varying water supply available to petitioner, there were further problems arising from variations in demand for electrical service. Electricity cannot be manufactured and stored for subsequent delivery but must be generated as and when it is demanded by the customer. Such demand varies with the hours during a day, the days in a week, and the months in a year.

The variations in demand during different hours of a day are illustrated by a typical daily "load" chart, introduced in evidence, showing customer consumption of petitioner's electricity on Monday, September 28, 1936. The chart shows a midnight load of 342,000 kilowatts, declining to about 300,000 kilowatts after 1 a. m. and remaining at about that level until somewhat after 5 a. m.; thereupon, a sharp rise brought the load to over 500,000 kilowatts shortly after 7 a. m., and a morning peak of 525,400 kilowatts was thereafter attained; at noon the curve dipped somewhat, and it remained at about 500,000 kilowatts until 4 p. m., when a sharp rise began, culminating in a peak of 623,900 kilowatts about 6:30 p. m.; thereafter the curve declined steadily during the evening hours, ultimately going below 400,000 kilowatts.

On the day to which the foregoing load chart pertains, petitioner had to have sufficient capacity to carry the morning peak load of 525,400 kilowatts and the evening peak load of 623,900 kilowatts. A portion of that generating capacity remained idle during portions of the day, and particularly during the early morning hours, when the demand dropped to about one-half the peak for the day. Thus, as was characteristic of petitioner's industry, it was impossible from a practical standpoint fully to utilize petitioner's maximum productive capacity during all hours of the day and night, because that capacity could not be fitted into the pattern of daily demand or "load curve."

Petitioner's peak demand in 1939 occurred on September 22, at 6:33 p. m., and amouted to 684,500 kilowatts. Excluding power petitioner was by that time in a position to receive from Boulder Dam, as described hereinafter, petitioner had available 796,500 kilowatts at the time of that peak.

As to variations in demand during different days of a week, it was typical of petitioner and its industry that the demand for kilowatt-hours was lower on Saturdays, and much lower on Sundays and holidays, than it was on week days.

The variations in demand during different months of the year are reflected in the following table of total production (in millions of kilowatt-hours) of petitioner's hydro and steam plants during the 10-year period 1930-1939, inclusive, indicating that on the average the demand for kilowatt-hours in July and August was roughly one-third greater than in the months from November through March:

Month	1930	1931	1932	1933	1934	1935
January	240	233	207	201	214	214
February	216	201	192	170	193	196
March	237	256	220	203	227	223
April	256	267	248	226	248	236
May	244	256	253	232	266	264
June	278	273	262	243	256	289
July	328	313	276	276	290	309
August	324	296	273	280	286	311
September	280	255	245	248	255	283
October	271	263	242	242	234	278
November	239	220	220	220	208	256
December	237	210	207	221	216	260
1 Totals	3,150	3,045	2,845	2,760	2,893	3,118

					10-year
Month	1936	1937	1938	1939	average
January	257	235	221	226	225
February	233	213	202	202	202
March	263	230	223	235	232
April	268	233	230	234	245
May	305	267	252	278	262
June	323	288	273	329	281
July	358	324	301	318	309
August	356	321	310	322	308
September	328	285	283	274	274
October	304	263	263	215	258
November	239	236	242	206	229
December	242	229	239	190	225
1 Totals	3,475	3,123	3,039	3,029	3,048

The following is a comparison of the peak demands in the indicated years, showing the month of the highest peak and the month of the lowest peak (in kilowatts):

	Lowest of	Highest of
Year	monthly	monthly
	peaks	peaks
1935	Mar. 454,800	Dec. 561,900
1936	Feb. 521,600	Oct. 645,400
1937	Apr. 494,900	July 580,500
1938	Mar. 489,100	Nov. 579,000
1939	Apr. 512,000	Sept. 684,500

Petitioner had to have sufficient capacity in a given year to meet the highest peak demand of that year. If that peak remained constant 24 hours a day throughout the year, the number of kilowatt-hours that would be demanded would be equal to the kilowatts of that peak multiplied by 8,760 (the number of hours in a year). The difference between the resulting figure and the number of kilowatt-hours actually required to be generated during that year represents the kilowatt-hours that could not be sold or fitted into the "load curve." Only about 60 per cent of the "theoretical maximum" thus capable of sale by petitioner actually could be sold or fitted into the load curve. The following table shows the highest peak demands in the indicated years, and the relation between the electricity theoretically salable, on the basis of those peaks, and the power actually sold by petitioner:

	(1)	(2)
		Kilowatt-hours
		that would have
	Annual	been generated if
Year	highest	highest peak demand
	peak demand	had been
	(in	constant 24 hours
	kilowatts	a day throughout
		the year
		(peak x 8,760)
1923	312,500	2,737,500,000
1924	330,710	2,897,020,000
1925	395,900	3,468,084,000
1926	422,700	3,702,852,000
1927	448,900	3,932,364,000
1928	516,100	4,521,036,000
1929	571,000	5,001,960,000
1930	582,900	5,106,204,000
1931	558,200	4,889,832,000
1932	516,500	4,524,540,000
1933	508,700	4,456,212,000
1934	516,300	4,522,788,000
1935	561,900	4,922,244,000
1936	645,400	5,653,704,000
1937	580,500	5,085,180,000
1938	579,000	5,072,040,000
1939	684,500	5,996,220,000

	(3)	(4)
		Column 3 as
		a per cent of
Year	Kilowatt-hours	column 2 -- the
	1 actually transmitted	per cent
		which could be
		fitted into the
		load curve
1923	1,548,896,000	57
1924	1,687,888,000	58
1925	1,998,857,000	58
1926	2,227,880,000	60
1927	2,421,357,000	62
1928	2,762,460,000	61
1929	3,162,988,000	63
1930	3,168,973,000	62
1931	3,061,837,000	63
1932	2,856,603,000	63
1933	2,772,640,000	62
1934	2,917,593,000	65
1935	3,139,307,000	64
1936	3,492,532,000	62
1937	3,138,654,000	62
1938	3,058,174,000	60
1939	3,622,973,000	60

Column 4 in the foregoing table indicates the "load factor." The difference between 100 per cent and the load factor represents productive capacity not sold during the indicated years. Such a condition is not unique to petitioner: a load factor of 60 to 65 per cent was higher than the average load factor in petitioner's industry, which ranged from 50 to 55 per cent in the decade from 1930 through 1939.

The Reserves.

In the "prudent" conduct of its business, petitioner considered it desirable to set aside a portion of its productive capacity as "reserves." The "reserves" were as follows: (1) Spinning reserve. This reserve consisted of "unloaded generating capacity that is operated on the line and is instantly available for production for load, primarily for the purpose of emergencies such as the loss of loaded generating capacity or the loss of certain sections of transmission system that may impair generation and transmission of energy." Spinning reserve was also used in meeting peak demands, thus helping to "take the swings in load." Spinning reserve commonly was provided by keeping generating units operating at less than full capacity, the margin between the level of operation and full capacity representing the reserve. The spinning reserve was thus spread over more than one unit; and these units might be steam or hydro, or a combination of both. To the extent and for the period that spinning reserve is called into use, it ceases to be a reserve, and in some circumstances it becomes necessary to replenish the spinning reserve. During the base period years, petitioner considered it desirable to keep about 100,000 kilowatts of its own productive capacity as spinning reserve, although the report of one of its engineers indicated the possibility of getting along with a spinning reserve of 70,000 kilowatts. (2) Standby reserves. Where there are hydro units in a system, reserves are needed as protection against insufficient water in dry years. Reserves for this purpose are provided by steam plants. During the base period, petitioner considered it desirable to keep a standby reserve of its own productive capacity of about 55,000 kilowatts for its stream-flow plants and about 160,000 kilowatts for its reservoir plants. (3) Cold reserves. These consisted of old, less efficient steam plants which were used as "back-up protection" in case of outages; or to replenish the spinning reserve, as during a long breakdown; or to provide part of the standby reserves. These old plants were not kept in operation, but were put into production as their capacity was needed. To the extent that petitioner maintained such cold reserves during the base period, petitioner considered it desirable to keep cold reserves of about 35,000 kilowatts.

On a growing utility system, it is "very difficult" to maintain the quantity of reserves just described. Petitioner attempted "as best we could" to approach reserves in the aforementioned amounts. The productive capacity actually kept in reserve by petitioner changed from time to time.

Where capacity is sold which has been set aside for reserve purposes, it is ordinarily no longer available as a reserve during the period in which it is sold.

During the base period, petitioner could rely to some extent on power systems besides its own as a source of reserve productive capacity in the event of emergency. It had arrangements, described hereinafter, with other producers of electricity which enabled petitioner to obtain electric power from them in an emergency.

The Coming of Boulder Dam and Allocation of its Power.

The Colorado River rises in the mountains of Wyoming and Colorado, and flows about 1,700 miles through seven states, emptying into the Gulf of California. The territory thus traversed includes a so-called upper basin, covering the drainage area in Wyoming, Utah, Colorado, and New Mexico; and a so-called lower basin covering the area in Nevada, Arizona, and California. The dividing line is regarded as being at Lee's Ferry, Arizona. However, there is in fact a 400-mile area of high, rocky terrain which separates the two basins. This area is known as the "canyon region," through which the river has forced its way since prehistoric times and has cut a series of deep canyons. These gorges begin at Lee's Ferry, Arizona, and end at Black Canyon.

All the states tributary to the river were interested in its water, and, to resolve to some extent conflict arising through appropriation of the water by some at the expense of others, an interstate agreement, known as the Colorado River Compact, was executed in 1922. The United States, by the Boulder Canyon Project Act (45 Stat. 1057), which became law on December 21, 1928, approved the compact upon the condition, among others, that it should become effective when ratified by six of the states. Of the seven states, Arizona alone withheld ratification at that time, and, in 1944, Arizona also ratified the compact.

For California, the Colorado River was important in several respects. First, southern California, particularly the Imperial Valley and its contiguous area, was subject to annual flooding by the river. A very serious flood in 1905 gave impetus to consideration of a dam on the river for the purpose of flood control. Secondly, the same area consisted of rich but water-deficient farmland, for which water was needed for purposes of irrigation and reclamation. However, at times of the year when the river was not threatening the area with inundation, it often became so reduced in volume as to be a grossly inadequate source of water. Moreover, the water resources of the entire area then in use were being depleted with rising consumption, and there was a need of additional sources of water to sustain domestic and economic activity in the area. Finally, control of the river could add substantially to the power available in the area; petitioner had investigated development of power on the river, and prior to 1920 had sought to build a dam on it.

By the 1920s the area served by petitioner, a semiarid region, had become acutely aware of its need for additional water. Underground water resources were receding to a substantial degree. In 1928, pursuant to California statute, the Metropolitan Water District of Southern California (hereinafter referred to as the "Water District") was organized, a public corporation composed of 13 cities in southern California, the object of which was to develop water supplies for those communities. In 1931 the voters of the District approved a $ 220,000,000 bond issue to build an aqueduct to bring water from the Colorado River, a distance of some 240 miles. That project was based upon the assumption that a dam would be built at Boulder Canyon, and relied also upon the construction of another dam further downstream.

These circumstances culminated in action by the Federal Government in 1928. The Boulder Canyon Project Act in that year authorized construction by the United States of Boulder Dam ³ and incidental power facilities on the Colorado River.

Thereafter, the Secretary of Interior of the United States, on directing the Commissioner of Reclamation to begin construction of Boulder Dam, issued a statement in July 1930 in which he said:

The Boulder Dam will signalize our national conquest over the Great American Desert. With dollars, men, and engineering brains we will build a great natural resource. We will make new geography, and start a new era in the southwestern part of the United States. With Imperial Valley no longer menaced by floods, new hope and new financial credit will be given to one of the largest irrigation districts in the West. By increasing the water supply of Los Angeles and the surrounding cities, homes and industries are made possible for many millions of people. A great new source of power forecasts the opening of new mines and the creation of new industries in Arizona, Nevada, and California.

In the deliberations and negotiations preceding enactment of the Boulder Canyon Project Act (hereinafter also referred to as the "Boulder Act"), income from the sale of power was taken to be necessary to make the project self-supporting, and it was revenue from sale of power to be generated at the dam that was relied on to finance it. Studies were made of the market for power in Southern California, and it was concluded that there would be an ample market for the probable power generated by such a project.

The Boulder Act established a "Colorado River Dam fund," to which the Secretary of the Treasury was authorized to advance $ 165,000,000. Before this amount was to become available and before construction on the dam was to be undertaken, however, it was required by the Act that "the Secretary of the Interior shall make provision for revenues by contract * * * adequate in his judgment to insure payment of all expenses of operation and maintenance of said works incurred by the United States and the repayment, within fifty years from the date of the completion of said works, of all amounts advanced to the fund * * * for such works, together with interest thereon made reimbursable under this Act." (Sec. 4 (b).)

On April 26, 1930, the United States entered into two contracts: (1) one with the City of Los Angeles (hereinafter also referred to as the "City") and petitioner, severally, in which the power facilities at Boulder Dam were leased to them, and in which in effect the City agreed to buy 37 per cent and petitioner 27 per cent of the "firm energy" to be generated at Boulder Dam, ⁴ this contract to remain in effect until the expiration of a period of 50 years from the date on which energy became ready for delivery to the City; and (2) one with the Water District, in which it undertook to purchase power generated at Boulder Dam.

The Secretary of the Interior determined, and so reported to Congress on June 16 and 17, 1930, that the aforesaid contract of April 26, 1930, with the City and petitioner, would be sufficient in his judgment to provide an income required under the statute. Based upon such assurance, appropriated funds were made available to begin construction. The construction contract was awarded on April 20, 1931, allowing until April 11, 1938, for completion. But the dam and related power plant structures were completed on March 1, 1936, two years ahead of schedule; dedication of the dam by President Roosevelt took place on September 30, 1935.

The dam is 726.4 feet high. Its reservoir, Lake Mead, extends 115 miles upstream, and has a shore line of 550 miles, a surface area of 254 square miles, and a storage capacity of 32,359,000 acre-feet of water. The related power plant was designed for 15 large generators and two smaller generators, with an aggregate capacity of 1,322,300 kilowatts.

The first generator at Boulder Dam was completed on October 9, 1936, and it was installed for the City of Los Angeles. By that time the City had completed a transmission line from Boulder Dam, and delivery of energy from the dam to the City began on October 26, 1936. Petitioner started to build a transmission line to Boulder Dam in 1936, and the line was completed by July 1, 1938, although certain "terminal facilities" relating to that line were not completed until November 1938. This line had a capacity of 165,000 kilowatts. Installation of the first generator for petitioner at Boulder Dam was completed in June 1939, and installation of a second generator for petitioner at Boulder Dam was completed in September 1939. Each of these generators had a rated capacity of 82,500 kilowatts. Petitioner began to receive power from Boulder Dam in June 1939.

The following table shows the beginning service dates and capacities of generators installed at Boulder Dam, and the names of the parties for which the installations were made:

			KW
			nameplate
			rating
Oct. 26, 1936	N2 City of L. A	82,500
Nov. 14, 1936	N1 City of L. A	82,500
Dec. 28, 1936	N4 City of L. A	82,500
			247,500
Mar. 22, 1937	N3 City of L. A.	82,500
Aug. 16, 1937	A8 Calif. Electric Power	40,000
			122,500
June 26, 1938	N5 Metropolitan Wtr. Dist	82,500
Aug. 31, 1938	N6 Metropolitan Wtr. Dist	82,500
			165,000
June 19, 1939	A7 So. Calif. Edison	82,500
Sept. 12, 1939	A6 So. Calif. Edison	82,500
			165,000
Oct. 22, 1941	A1 City of L. A		82,500
July 11, 1942	A2 City of L. A		82,500
Jan. 13, 1943	A5 So. Calif. Edison		82,500
Nov. 1, 1944	N7 Nevada		82,500

The foregoing contract of April 26, 1930, between the United States and the City and petitioner, divided the electric energy to be generated at Boulder Dam into two categories: (1) "Firm energy," which consisted of the first 4,240,000,000 kilowatt-hours generated during the first year, declining by 8,760,000 kilowatt-hours each year thereafter; and (2) "secondary energy," consisting of all electric energy generated in excess of firm energy. At the time the contract was entered into, the United States Bureau of Reclamation estimated that the secondary energy would amount to about 1,550,000,000 kilowatt-hours per year, declining each year by 8,600,000 kilowatt-hours.

Under the terms of this contract of April 26, 1930, petitioner was to pay for firm energy at the rate of 1.63 mills per kilowatt-hour. Secondary energy purchased by petitioner was to be paid for at the rate of one-half mill per kilowatt-hour.

The contract of April 26, 1930, required the United States to provide and install the machinery and equipment needed at the dam for generation of electric power. These power units and other facilities for generating power were leased in that contract to the City and petitioner, with certain of the facilities leased to one and the remainder leased to the other, and both of them agreed to operate the facilities and to supply specified percentages of power to designated purchasers to which Boulder Dam power was allocated. These allottees, besides petitioner and the City of Los Angeles, consisted of the states of Arizona and Nevada, certain municipalities, the Water District, and certain privately-owned power companies. The plan was, however, that only the City and petitioner were to operate the Boulder Dam power facilities, and they were to generate the power to be provided to the various allottees; that the City and petitioner were to take respectively the 37 per cent and 27 per cent blocks of power mentioned above; and that certain of the allottees were to receive their portion of the power from the blocks allotted to the City and petitioner. The City and petitioner would be left with reduced amounts of power if these allottees all took the portion of the power allocated to them. Power for the states, the municipalities, and the Metropolitan Water District was to come from facilities operated by the City; power for the private utilities was to come from facilities operated by petitioner.

To the Water District there was allocated 36 per cent of the firm energy for the purpose of pumping Colorado River water into and in an aqueduct it planned to build. The firm energy allocated to and unused by the Water District was to be made available to the City and to petitioner. The Water District was given first call on all the secondary energy; the City was allotted 50 per cent of the secondary energy, subject to the Water District's first call; and petitioner was allotted 40 per cent of the secondary energy, subject to the Water District's first call.

Under the foregoing contract of April 26, 1930, the City was obligated to begin taking Boulder Dam power when the Secretary of the Interior announced that 1,250,000,000 kilowatt-hours of energy per year were ready for delivery. The contract, both as to the City and petitioner, ran for a term of 50 years beginning with that time. Starting with the time it was required to begin taking Boulder Dam power, the City was allowed under the contract a 4-year period within which to absorb its full commitment: 55 per cent in the first year, 70 per cent in the second year, 85 per cent in the third year, and 100 per cent in the fourth and all subsequent years. Petitioner was obligated to begin taking Boulder power on the occurrence of certain conditions but not sooner than 3 years after commencement of delivery of power to the City; provided, however, that the Secretary of the Interior could compel petitioner to take such power when petitioner attained a demand for its power at least equal to its maximum demand at any time during the 12-month period preceding the date on which the City started to take its power. Petitioner was allowed a 4-year period, like that of the City, in which to absorb its full commitment from the time it began to take Boulder Dam power.

In accordance with these provisions, the City was not obligated to begin taking Boulder Dam power until June 1, 1937. But under an interim contract it took such power from October 26, 1936, until June 1, 1937. Petitioner was not obligated to begin taking power until June 1, 1940. Prior thereto, on October 14, 1938, petitioner also entered into an interim contract with the United States concerning sale to petitioner of Boulder power, under which petitioner began to receive such power in June 1939.

Power from Boulder Dam was also allocated, in the foregoing contract of April 26, 1930, to the cities of Burbank and Glendale, California. These cities began to take power from Boulder Dam in the early part of 1937.

Loss of Sales to the Cities.

At one time, electric power within the cities of Los Angeles, Burbank, and Glendale had been supplied by petitioner. In 1918, Los Angeles, under threat that it would condemn those properties, purchased petitioner's distribution properties in that city. From 1918 through 1922, petitioner maintained those properties and delivered energy directly to consumers within the City, and billed the City at wholesale rates. In or about 1923, the electric distribution systems in Burbank and Glendale likewise were municipally owned. From 1923 through 1936, petitioner sold electric energy at wholesale rates to the cities of Los Angeles, Burbank, and Glendale, for redistribution by them through their municipally owned systems. When these cities started to take power from Boulder Dam, as found above, petitioner's sales to these cities at wholesale rates for resale purposes were largely discontinued.

The provision in the contract of April 26, 1930, that petitioner would commence taking Boulder power 3 years after the City of Los Angeles started to take its power from Boulder Dam, was inserted in the contract in recognition of the fact that, as Boulder power became available, petitioner would lose the City as a wholesale customer, and this provision contemplated a 3-year period within which petitioner might replace the lost load before beginning to take energy itself from Boulder Dam.

During the years 1923 through 1936, the cities of Los Angeles, Burbank, and Glendale bought power from petitioner as follows:

	Petitioner's	Revenues	Per cent
Year	gross L & P	from sales to	of total
	revenue	3 cities
1923	$ 19,766,604	$ 1,618,755	8.1893
1924	20,932,441	2,131,950	10.1849
1925	24,283,624	2,798,910	11.5259
1926	27,377,616	2,621,428	9.5751
1927	30,053,498	2,903,632	9.6615
1928	34,515,717	3,636,217	10.5350
1929	39,602,660	3,931,043	9.9262
1930	40,355,906	3,761,464	9.3207
1931	40,102,232	3,798,482	9.4720
1932	36,867,847	3,379,705	9.1671
1933	35,039,568	2,953,844	8.4300
1934	35,741,762	3,107,701	8.6949
1935	37,356,221	3,355,642	8.9828
1936	41,274,000	3,381,122	8.1919
14-year average			9.4184

	Petitioner's	KWH
	total KWH	sales to	Per cent
Year	deliveries	3 cities	of total
	(1000's)	(1000's)
1923	1,180,142	184,007	15.5919
1924	1,353,934	259,595	19.1734
1925	1,558,261	318,552	20.1223
1926	1,764,635	323,165	18.3134
1927	1,877,205	361,371	19.2505
1928	2,215,648	441,305	19.9177
1929	2,591,177	510,512	19.7019
1930	2,615,234	535,936	20.4929
1931	2,551,331	530,961	20.8111
1932	2,287,273	464,035	20.2877
1933	2,231,754	463,305	20.7597
1934	2,396,430	550,101	22.9550
1935	2,517,054	589,810	23.4326
1936	2,811,171	567,151	20.1749
14-year average			20.0704

				Petitioner's	KWH
	Petitioner's	Revenues	Per cent	total KWH	sales to	Per cent
Year	gross L & P	from sales to	of total	deliveries	3 cities	of total
	revenue	3 cities		(1000's)	(1000's)
1 1937		$ 991,164			53,689
1938		604,555			13,299
1939		893,956			44,100
1940		783,375			25,677
1941		626,440			4,680
1942		604,272			4,341
1943		603,871			4,259
1944		627,740			8,440
1945		620,528			6,565

The sales and revenues involved in the foregoing table came from the individual cities as follows:

KWH SALES
Year	City of	City of	City of	Total
	Los Angeles	Burbank	Glendale
1923	168,117,221	4,691,800	11,197,647	184,007,000
1924	240,978,179	4,914,240	13,702,224	259,595,000
1925	296,117,888	5,495,450	16,938,671	318,552,000
1926	296,919,484	6,541,500	19,704,290	323,164,000
1927	328,955,256	7,072,346	25,343,579	361,371,000
1928	403,923,944	7,891,335	29,490,000	441,305,000
1929	467,267,435	8,833,500	34,411,200	510,511,000
1930	489,320,327	8,901,000	37,715,137	535,936,000
1931	481,881,382	9,130,500	39,949,566	530,961,000
1932	415,938,864	8,476,163	39,620,274	464,035,000
1933	416,209,640	7,993,939	39,101,100	463,305,000
1934	499,753,855	8,845,310	41,502,000	550,101,000
1935	532,066,258	13,724,720	44,019,000	589,810,000
1936	497,765,894	19,252,122	50,133,000	567,151,000
1937	13,341,956	14,174,339	26,172,600	53,689,000

REVENUES
Year	City of	City of	City of	Total
	Los Angeles	Burbank	Glendale
1923	$ 1,457,416.40	$ 52,882.52	$ 108,456.51	$ 1,618,755.43
1924	1,956,114.66	49,992.85	125,842.19	2,131,949.70
1925	2,588,232.82	55,753.29	154,924.26	2,798,910.37
1926	2,378,408.46	63,953.10	179,066.05	2,621,427.61
1927	2,606,944.62	66,634.65	230,052.69	2,903,631.96
1928	3,298,199.49	73,317.18	264,700.80	3,636,217.47
1929	3,541,851.23	81,203.70	307,987.74	3,931,042.67
1930	3,341,601.36	82,215.50	337,647.05	3,761,463.91
1931	3,360,570.61	82,912.50	354,999.11	3,798,482.22
1932	2,950,595.53	77,726.81	351,383.09	3,379,705.43
1933	2,534,871.89	73,171.32	345,791.22	2,953,834.43
1934	2,664,340.47	79,654.27	363,706.20	3,107,700.94
1935	2,844,183.20	124,711.32	386,747.40	3,355,641.92
1936	2,770,975.49	171,997.86	438,148.80	3,381,122.15
1937	39,168.96	135,036.85	241,957.92	416,163.73

On July 1, 1939, under threat of condemnation, petitioner sold to the City of Los Angeles that portion of its electric distributing system which was located in territory which had been annexed to the City but which had been served by petitioner for many years. This sale resulted in the loss of 53,449 customers, sometimes referred to as "fringe customers." In the same transaction, petitioner purchased from the City certain electric distributing facilities located outside the City which resulted in the acquisition of 9,745 customers formerly served by the City. The net effect was a loss to petitioner of 43,704 customers and approximately $ 1,500,000 annual gross revenue.

During the period from 1917 to 1947, inclusive, the other areas and customers lost by petitioner, under threat of condemnation, to municipal utilities were the following:

		Number of	Annual
Year	Areas	customers	revenue
		lost	lost
1919	City of Glendale
	Tropico Annexation	731	$ 20,424
1920	City of Pasadena	3,718	162,997
1921	City of Pasadena
	Lamanda Park Annexation	782	25,759
1924	City of Pasadena
	Cheviotdale Tract	6	156
	Avondale Tract	30	782
1925	City of Pasadena
	Vineyard Annexation	13	345
	Santa Anita Annexation
	Lamanda Park No. 2 Annexation	263	6,985
	University Annexation
1925	City of Glendale
	Four small areas along West Boundary of Glendale	73	1,939
1926	City of Glendale
	Sparr Heights Annexation	73	2,077
1927	City of Pasadena
	Eaton Annexation	207	6,126
1930	City of Pasadena
	Bonestell Annexation	86	2,722
	Lombardy Annexation	4	127
1934	City of Burbank
	Annexed Area on West Side	1,883	63,212
1941	City of Los Angeles
	Woodlands Annexation	54	2,395
1942	City of Pasadena
	Loma Vista Annexation	23	960
1944	City of Los Angeles
	Florence No. 3 Annexation	3	137
1945	City of Pasadena
	Sierra Bonita Annexation	21	1,076
	Parkwood Annexation	33	1,691
1946	City of Pasadena
	Woodlyn Annexation	102	5,633
	Queensberry Annexation	531	29,327
	Greenwood Annexation	96	5,302
	Asbury Annexation	161	8,892
	Maple Annexation	244	13,476
1947	City of Pasadena
	Oak Annexation	738	41,911

Sales to P G and E.

In anticipation of the loss of the foregoing wholesale business of the three cities (Los Angeles, Glendale, and Burbank), petitioner executed a contract on September 3, 1936, with San Joaquin Light and Power Corporation (hereinafter referred to as "San Joaquin"), a subsidiary of Pacific Gas and Electric Company (hereinafter referred to as "P G and E"). In this contract it was provided that "whenever the name of San Joaquin is used herein it will be deemed to comprehend the Pacific [P G and E] system." This contract contained the following recitals:

WHEREAS San Joaquin will at times during the next ten or more years require electric energy and/or an assured kilowatt capacity greater than that which is now available to it from its existing generating facilities and under its current obligations to purchase from other sources, and rather than to construct additional generating plants at this time San Joaquin may desire during that time to purchase part or all of such requirements, both electric energy and/or kilowatt capacity, from Edison if and when and to the extent that the latter can supply same; and

WHEREAS Edison will during said period or longer have electric energy and assured kilowatt capacity in its existing facilities and/or which it is under existing obligation to purchase from other sources over and above its own utility requirements and is willing to obligate itself to supply portions thereof to San Joaquin; and

WHEREAS San Joaquin may itself from time to time have surplus electric energy which Edison may desire to purchase; and

WHEREAS it is the mutual intention of the parties hereto that electric energy will be interchanged hereunder at all times when it is warranted by their respective operating conditions; and

WHEREAS to permit of interchange of energy between them if and when and to the extent they shall from time to time require San Joaquin and Edison have decided that an interconnection between their respective systems will be of mutual advantage;

The contract provided for the construction of two transmission lines between petitioner's system and the P G and E system, and petitioner agreed to make available to San Joaquin a capacity of 40,000 kilowatts and to deliver to it no more than 280,000,000 kilowatt-hours per year. The contract provided for a board composed of representatives of the contracting parties, and one of the functions of this board was as follows:

In addition to performing the foregoing duties, said board shall also from time to time give consideration to the desirability of further interchange of energy between the two systems, and to this end Edison and San Joaquin will at all times keep readily available for the information of said board all operating data on all generating plants of their respective systems which shall have any bearing on the out-of-pocket cost or the alternative cost of energy on such system. Relying on such data, said board may from time to time recommend to the parties hereto that in its opinion additional energy could be advantageously so interchanged. Said board may also determine if, when and to what extent additional assured capacity shall be required by San Joaquin, and in the event San Joaquin shall elect to receive such additional assured capacity from Edison said board shall determine the deferred plant cost thereof.

The contract terminated June 30, 1947, unless extended by mutual agreement, and it might be sooner canceled as follows:

Edison agrees that if and when its own load shall increase so that it will no longer be able to guarantee part or all of any given assured kilowatt capacity, the construction of which is deferred hereunder, it will give San Joaquin written notice to that effect at least one and one-half years in advance of such contingency, * * *

On or about November 25, 1936, pursuant to the provisions of the foregoing contract, petitioner agreed to make available to San Joaquin 35,000 kilowatts in addition to the 40,000 kilowatts already provided for in the foregoing contract of September 3, 1936. This additional 35,000 kilowatts was required to be provided during the period from July 1, 1938, through December 31, 1939. On or about April 12, 1939, petitioner agreed to extend through December 31, 1940, the period within which it was to provide this additional 35,000 kilowatts.

In the latter half of 1939 petitioner and P G and E negotiated for a further increase in the power thus sold by petitioner, and in or about April 1940 they entered into a contract (1) which extended through December 31, 1941, petitioner's obligation to supply the additional 35,000 kilowatts; (2) for the calendar years 1942, 1943, and 1944, petitioner agreed to provide P G and E with an assured capacity of 150,000 kilowatts and to deliver to it up to 815,000,000 kilowatt-hours per year; and (3) for the calendar year 1945, P G and E was given the right to obtain between 50,000 and 100,000 kilowatts from petitioner (instead of the 40,000 kilowatts originally contracted for), with a limitation on the number of kilowatt-hours to be supplied. The contract provided that petitioner would "at its own risk and expense proceed with the construction of any and all facilities necessary to provide and maintain the capacities required to furnish for Pacific during the respective periods herein mentioned the respective assured capacities and quantities of energy specified herein." It was further provided that "Pacific shall pay all costs of providing and installing the necessary additional interchange facilities required hereunder; provided, however, that for use in connection therewith Edison shall without cost to Pacific furnish the following appliances * * *."

These contracts between petitioner and P G and E were submitted to and approved by the Utilities Commission. As to the last of these contracts, the Utilities Commission issued an opinion dated April 10, 1940, in which the following appeared:

The evidence introduced at the public hearing held on March 29, 1940, reveals:

* * * *

4. That Edison, by constructing a second Boulder line and contracting with the Federal Government for a third 82,500 kilowatt unit at Boulder, reasonably could meet the demands of Pacific, as herein proposed, as well as meet the demands and furnish the necessary kilowatt-hours to its own customers that might reasonably be expected through load growth over this same period.

5. That the payments under the proposed First Supplemental Agreement by Pacific to Edison appear reasonable.

The Water Project Authority of the State of California appeared before the Commission and contended that the foregoing contract of 1940 between petitioner and P G and E should be made of shorter duration, and in this connection the Commission wrote in its opinion:

The suggestion that the Commission require such modifications apparently is made on the assumption that Pacific and Edison would enter into an agreement containing such conditions. While no witness testified specifically on this point, the record would tend to indicate that Edison would not enter into such an agreement. Mr. F. B. Lewis, Vice President of Edison, testified that his Company would not be justified in expanding its production facilities in the manner contemplated by the First Supplemental Agreement, unless assured of the revenue contemplated by the agreement for the full three-year term. It would appear, therefore, that Edison would refuse to execute the proposed agreement if the term thereof were shortened by action of the Commission. Assuming, however, that Edison would execute the shortened term agreement, it is questionable whether the Commission should authorize it. The record shows that Edison is taking a somewhat speculative risk in making an investment for production facilities not required by its present consumer demand, but which it is hoped can be utilized by Edison for consumer needs after the termination of the First Supplemental Agreement with Pacific. However, a load growth for Edison somewhat greater than has been experienced in the past will be necessary between now and the end of 1944, to prevent there being an excess of production capacity over Edison needs at that time. If Pacific's obligation should be subject to termination before the end of 1944, it seems quite clear that there would be excess capacity and resultant increased cost attendant thereto, which would become an additional burden on Edison and its consumers.

Under its contracts with San Joaquin and P G and E, petitioner received the following revenues and sold the following power (in kilowatt-hours):

Years	Revenues	KWH
1937	$ 139,949.54	9,412,435
1938	341,812.98	969,600
1939	1,167,139.77	431,589,600
1940	810,039.67	309,194,160
1941	979,158.93	442,641,200
1942	2,523,864.40	652,380,000
1943	2,781,648.25	822,348,740
1944	2,632,505.42	734,473,800
1945	1,148,062.97	332,920,720

On or about April 11, 1940, petitioner notified the Secretary of the Interior that it wanted installation of an additional generating unit of 82,500-kilowatt capacity at Boulder Dam, "together with the necessary turbines, transformers and other equipment, and that we desire that such additional unit be installed and ready for operation on January 1, 1942." Petitioner ordered installation of this additional unit at that time, and wanted the capacity that would become available through it, primarily because of the additional productive capacity it was making available to P G and E through its contract with P G and E executed in April 1940 and described above. It was largely for the same reason that at about that time petitioner built a second transmission line to Boulder Dam.

Lease of 60,000 Kilowatts to Los Angeles.

After sale to the City of Los Angeles of petitioner's distribution properties in that City, as found above, a contract was executed in 1919 by petitioner and the City in which petitioner was obligated to furnish and the City was obligated to purchase, for a period of 10 years beginning in 1922, all electric energy required by the City in excess of energy obtained by it from its own hydro plants and from the Los Angeles Gas & Electric Corporation.

At the expiration of this 10-year period, on May 23, 1932, petitioner made a written offer to the City to furnish it for 10 years with all energy it required in excess of the energy it obtained from its own hydro plants and from Boulder Dam.

In 1932, the City prepared plans and advertised for bids with respect to construction of its own steam-generating plants. On August 3, 1932, petitioner again submitted its offer to furnish steam-generated power to the City, and thereafter in August 1932 petitioner unsuccessfully sought to enjoin the City from constructing a steam plant.

On November 3, 1932, a contract was executed between petitioner and the City's Board of Water and Power Commissioners (also referred to herein as the "Board"). It contained the following recitals:

Whereas, after May 16, 1932, the existing contract between the City of Los Angeles and the said Board [of Water and Power Commissioners of the City of Los Angeles] and the Southern California Edison Company Ltd. permits the Board to generate part or all of its electric power requirements at either hydro-electric or steam generating plants owned or controlled by it, and in accordance with such provisions the Board contemplates immediate erection of a steam generating plant, and

Whereas, it appears that the best interests of the community as a whole may be served during the present depression and a return to normal business conditions, by the utilization of present power generating facilities or otherwise idle plant of the parties to said contract,

* * * *

The contract then provided:

(1) That the installation of additional generating capacity, either steam or hydro, shall be deferred by both parties to said contract so long as and insofar as the present total available capacity of the Board and the Company (including hydro capacity, the Long Beach steam capacity and also the amount of power that may be secured under the present commitments and rights to Boulder Canyon Project power, exclusive of Metropolitan Water District's 36 per cent allotment of firm power) may continue physically and economically available and is sufficient, in addition to an appropriate amount of total auxiliary and standby reserve capacity to provide the total of all electric power, or energy required to supply the present combined distributing systems of the Board and the Company, together with any extensions thereto that may be hereafter constructed; and, it is further understood, except as may be otherwise agreed at any time by the parties hereto, that all of said total electric power or energy requirement shall be provided from said present total available capacity during such period of time, and that either party shall obtain such service and/or purchase such energy from the other as may be necessary to the fulfillment of this understanding in accordance with the provisions of this supplemental agreement and of said contract.

* * * *

* * * When and as additional capacity is required in accordance with the above, the same shall be installed by the Board to the extent of meeting its total requirements.

* * * *

The contract further provided that "upon displacement by Boulder Canyon power of power supplied by the Company [petitioner] to the Board," the Board should lease from petitioner such power as it might require but not less than 60,000 kilowatts "for auxiliary and standby purposes"; and that if the Board leased an identified steam plant from petitioner having a 60,000-kilowatt capacity, together with transmitting facilities, it would pay the cost of fuel used at the plant plus $ 575,000 annually. The contract then provided:

Compensation for such generation and transmission shall be as mutually agreed upon from time to time.

The foregoing rental of $ 575,000 was paid by the City to petitioner for each of the years 1937 to 1947, inclusive.

Loss of Sale of Additional 100,000 Kilowatts to Los Angeles.

On November 6, 1937, after the City had already begun to receive power from Boulder Dam, its Department of Water and Power sent the following letter to petitioner:

As you are aware, * * * the Bureau of Power and Light finds it necessary to make provision for additional generating capacity by December of next year, in order to meet the estimated demands on its system, and must proceed at once to make such provision in order that the additional capacity may be ready when needed.

The Bureau plans to provide the additional capacity through the construction of a third transmission circuit from Boulder to Los Angeles, if certain negotiations, now pending with the Federal Government, are concluded in a manner justifying the Bureau in proceeding with such construction. If, however, the negotiations should not result in understandings justifying the construction of a third circuit, it will be necessary for the Bureau to immediately proceed with the construction of a steam plant at Los Angeles harbor.

* * * *

The letter then referred to the foregoing contract of November 3, 1932, and stated that within the terms of that contract the City could proceed to increase its power supply. The letter further stated:

If the ultimate decision should be to provide additional capacity through the construction of a third circuit [to Boulder Dam], the Department would clearly be within its rights, under the contract referred to, in proceeding with of a third circuit, it will be necessary for the Bureau to immediately proceed through the installation of steam generating capacity.

* * * *

In order to meet its needs the Department must have at least 100,000 kilowatts additional capacity as soon as it can be provided, and it is our understanding that your company would not be in a position to furnish this.

We believe, therefore, that the construction of such steam plant would not be, in any sense, a violation of the contract, and would greatly appreciate an assurance from your company that you concur in this view.

The Department will continue to lease the No. 9 unit in your Long Beach No. 2 plant under the terms of the agreement of November 3, 1932, until such time as your company may need the unit for its own use.

This is upon the understanding that the fact as to your needing that unit is to be determined with reference to the present available capacity of the company, as defined in the above quoted provision of the contract of November 3, 1932 -- that is to say, that such need is not to be deferred by the provision by you of "additional generating capacity" within the meaning of that contract.

This is to be subject to the further understanding that you will give the City not less than two years' notice of your need for said unit, and that the leasing of the unit may be terminated by either party on November 3, 1947, by two years' prior written notice to the other.

Petitioner replied to this letter as follows on November 12, 1937:

You further state that the Department will continue to lease the No. 9 unit of our Long Beach No. 2 plant, under the terms of the agreement of November 3, 1932, until such time as we need the unit for our own purposes, such need to be determined with reference to the present available capacity of the Company, as defined in said contract, and such continued leasing to be subject to the understanding that we will give you not less than two years' notice of our need for said unit, and that the leasing of the unit may be terminated by either party as of November 3, 1947, by two years' prior written notice to the other.

In compliance with your request, I beg to advise you that with the assurance given in your letter as to the continued leasing of the No. 9 unit, our company finds no conflict with said agreement of November 3, 1932, would result from the Bureau proceeding with the construction of either the third circuit to Boulder or the proposed steam plant.

Studies of Future Load Requirements.

In 1936, petitioner's engineers made studies of its estimated future load requirements and its estimated capacity to meet such requirements. One study, issued on or about December 11, 1936, concluded that it "appears essential that additional power be made available from some source for use during the last half of 1939. A single unit at Boulder of capacity of 82,500 kilowatts would assure adequate supply for 1939 and probably for 1940, but should the estimated rate of growth continue additional capacity would be required in 1941." In this study it was estimated that, after allowing for reserve capacity considered sufficient, petitioner's total remaining capacity would be about 701,000 kilowatts in the months of August, September, and October of 1939, whereas the load for those months was estimated to require 709,000, 707,000, and 705,000 kilowatts, respectively.

A second study, issued on or about December 14, 1936, concluded that "we should immediately order our first unit installed [at Boulder Dam], to be completed as soon as possible and the second unit to be completed by July 1, 1940. Steps should be taken toward obtaining the use of both Metropolitan [Water District] units from the time our Boulder line is completed until the District needs one of these units or until our first unit is installed and the use of the second Metropolitan unit up to the time when they will need it or until our second unit is completed." As to availability of Boulder power, it was concluded that it was "quite sure that there will be surplus Boulder power available and since we are constructing our Boulder line, we should be sure that we will have generating capacity available for this line."

This study further stated respecting the Boulder units of the Water District:

Our Boulder transmission line is being constructed with the thought that the Metropolitan District's generators will be available for our use prior to the time they will be needed to supply the District's requirements. The latest estimate on the District's requirements indicate however that they will need their units early in 1939 as indicated by the following table:

Metropolitan District's Energy Requirements
	Kilowatts	Kilowatt-hours
1938	34,000	150,000,000
1939	66,000	300,000,000
1940	102,000	700,000,000
1941	102,000	750,000,000

* * * *

The Metropolitan District is now having installed two units with one bank of transformers, therefore if we wish to make use of either of these units at the same time as the District has a demand for energy we must install a transformer bank for use in connection with our line. The District expects to use at least one of its units for testing purposes in 1938 and for pumping in 1939 and both units will be needed for pumping in 1940.

Thereafter petitioner's chief engineer wrote the following letter to one of petitioner's executives in December 1936:

A number of studies have been made in the past to determine when Boulder Canyon power would be needed in our system. Two such studies have been made within the last two weeks, one by Mr. Andree and one by Mr. Gulick, copies of which are attached. I have also discussed this matter in detail with Mr. Tice and we are all of the opinion that official notice should be sent to the Government at this time covering the installation of generating equipment for the Southern California Edison Company Ltd. at the Boulder power plant.

Our contract with the Government calls for a notification to the Secretary of the Interior of the dates and capacities which we will require. I wish to recommend that the first unit of 82,500 Kva., together with the necessary turbine, transformers, etc. should be installed and ready for service July 1, 1939; the second unit of like capacity to be ready for service one year later, i. e., July 1, 1940.

In Mr. R. F. Walter's letter to you of December 15, 1936, he stated "Approximately two years are required to purchase and install equipment of this size". Our contract with the Government states that we must give them 3 years' notice. From Mr. Walter's figure of approximately 2 years, we are led to believe that the Bureau of Reclamation can install a unit of this size in less time than the 3 years mentioned in the contract. Our first unit will be similar to those installed for the City of Los Angeles, except for minor details, so that most of the preliminary design work has been done. Also, the construction organization at the Boulder plant have had considerable experience in installing the City's units. With this in mind, we feel that in addition to the definite commitment of July 1, 1939, an effort should be made to see if it will be possible for the Bureau of Reclamation to install the first unit and have it ready for operation in July 1938, at the time we expect to have the Boulder-Chino 230 kv. transmission line completed.

We have been going over the specifications for the City's units with the idea of revising them to fit our conditions, and have drawn up the specifications for our transformers. This work is practically completed and we would be able to send preliminary specifications to the Bureau of Reclamation within the next 2 weeks.

As you know, we have been planning to use Metropolitan Water District generators and transformers temporarily to generate power for transmission over our line in 1938. The M. W. D. plan on testing their various pumping plants during 1938 and actually starting operation of the whole aqueduct as a unit in 1939. This might necessitate the installation of a temporary bank of transformers in connection with the Metropolitan Water District generator to enable us to take delivery of 50 cycle energy from one generator at the same time they are using the other generator for their own 60 cycle load. All of this could be avoided if it were possible to have one complete generating unit ready for operation by July 1938. An additional advantage would be that Peterson coils could be installed at this time with our equipment and certain savings could be made on the transmission line due to this fact.

Of course it may not be possible for the Bureau of Reclamation to make the installation in 18 months but we feel that, under the circumstances, it might be accomplished and we should at least notify them to this effect and get their reaction.

In 1936, petitioner's employees or officers made estimates of the "surplus capacity" (or capacity in excess of that needed for delivery) it expected to have in the years 1938 and 1939. These estimates assumed water conditions similar to those which petitioner experienced in 1931, its second driest year. Taking into account delivery of Boulder power to begin in 1939, petitioner estimated its surplus capacity as follows:

	1938	1939
Month
	KW	KWH	KW	KWH
January	242,000	60,000,000	223,000	84,000,000
February	266,000	51,000,000	248,000	80,000,000
March	221,000	60,000,000	201,000	90,000,000
April	141,000	97,000,000	115,000	113,000,000
May	214,000	99,000,000	191,000	108,000,000
June	148,000	71,000,000	1 290,000	1 178,000,000
July	110,000	57,000,000	250,000	165,000,000
August	107,000	49,000,000	248,000	158,000,000
September	151,000	47,000,000	294,000	156,000,000
October	155,000	41,000,000	297,000	154,000,000
November	153,000	37,000,000	296,000	126,000,000
December	205,000	77,000,000	339,000	113,000,000

Boulder Power Received by Petitioner.

Based on the foregoing studies, petitioner sent a formal notice to the Secretary of the Interior on or about January 21, 1937, requesting that one generator of 82,500-kilowatt rated capacity be installed for use by July 1, 1939, and that a second generator of like capacity be installed for use by July 1, 1940. Petitioner's contract of April 26, 1930, required such notice 3 years in advance of completion of installation; but petitioner had been advised by the chief engineer of the Bureau of Reclamation that the equipment could be bought and installed in about 2 years.

On or about August 20, 1937, petitioner wrote as follows to the Secretary of the Interior:

Southern California Edison Company Ltd., by letter dated January 21, 1937, advised you of its initial generating requirements at the Boulder power plant, and that it desired one unit to be installed and ready for operation on July 1, 1939, and a second unit on July 1, 1940. From information received through the Bureau of Reclamation it appears that the contracts for the major items of equipment for the said two units provide for dates of delivery and completion, which will permit of the completion of the said two units as requested in our letter of January 21, 1937.

* * * *

From information received from the Metropolitan Water District this Company understands that the Metropolitan Water District will not be in a position to take in 1938 all of its firm power under its contract with the United States. From the time in 1938 when firm power is first made available to the Metropolitan Water District, to the time in 1940 when Southern California Edison Company Ltd. is first obligated to take firm power, it may be possible for Southern California Edison Company Ltd., during certain periods, to supplant electric energy generated at its steam electric generating plant at Long Beach with electric energy generated at the Boulder power plant, provided the cost of the Boulder power is less than the cost of fuel at Long Beach.

Southern California Edison Company Ltd. owns and operates, in connection with its hydroelectric generating plants at Big Creek, steam electric generating plants at Long Beach of approximately like capacity, and the efficient operation of its system requires that the hydro and steam electric generating plants be continuously maintained under operating conditions. Therefore, since the saving of fuel is the only item to be considered, the maximum amount which Southern California Edison Company Ltd. can afford to pay for falling water at the Boulder power plant is five tenths mill per kilowatt hour.

If an agreement can be reached between the United States, Metropolitan Water District and Southern California Edison Company Ltd., it is possible to arrange for the delivery of electric energy from the Boulder power plant to the Edison system by approximately July 1, 1938. In order to provide such delivery of electric energy it will require the use of one of the Metropolitan Water District's generators now being installed at the Boulder power plant and one of the transformer banks now on order for Southern California Edison Company Ltd., and the completion of the transmission line of Southern California Edison Company Ltd. from Boulder to Chino, California, which transmission line is now under construction.

On or about September 22, 1937, petitioner sent the following letter to the Acting Secretary of the Interior:

Replying to your letter of September 15, 1937, relating to the disposition of firm energy not required by the Metropolitan Water District of South California, as set forth in the enclosures with your said letter, please be advised that we do not desire to receive at the firm energy rate our initial share of said unused power, nor do we desire to receive at the firm energy rate our share of the portion of the unused power not taken by the other lessee.

Should disposition be made of such firm energy at a rate less than the firm energy rate, we desire to have the opportunity to purchase on equal terms and conditions our portion of such firm energy, in accordance with the contract of April 26, 1930, referred to in your said letter.

The following communication was sent by the chief engineer of the Bureau of Reclamation to the Commissioner of Reclamation on or about December 21, 1937:

2. Both the City and the Company have notified the Secretary that they do not desire to exercise their options to purchase unused Metropolitan Water District energy at the firm energy rate, and it appears that the way is now cleared for the Secretary to offer the District's unused energy to the City of Los Angeles, the Southern California Edison Company, and the NevadaCalifornia Electric Company at one-half mill per kw.-hr. It is suggested that the Secretary be requested to ascertain if the Metropolitan Water District is willing that this be done, and if so that the district counsel be instructed to prepare a draft of contract suitable to the Southern California Edison Company covering the sale of a portion of the District's unused energy to the Company.

3. As mentioned in office letter of September 23, 1937, to you, it is planned to temporarily generate this energy by means of one of the generating units now being installed for the district. This unit could be operated at 50 cycles and would be temporarily connected to one of the Edison Company's banks of transformers by means of a temporary cable connection across the tailrace of the power plant. It is presumed that this unit should be operated by the City of Los Angeles during such time as it is used to furnish power for the Edison Company, and that during this period the Edison Company should pay its proper share of operation and maintenance costs.

4. It is believed that the contract should cover the period until the Edison Company is obligated to take firm power under its present contract. During the early part of the period the energy would be furnished by one of the District's units operated by the City and during the latter part of the period after one of the Edison's Company's units is ready for service, it would be generated by the Edison Company unit which would be operated and maintained by the Edison Company.

Subsequently a preliminary draft of a contract was drawn up relating to purchase by petitioner of power allocated to the Water District, and, on examination of this draft, the following letter was sent by the chief electrical engineer of the Bureau of Reclamation to District counsel at Los Angeles on or about February 25, 1938:

* * * *

Paragraph 14 provides for the contract becoming effective June 1, 1938. We have recently received a letter from Mr. Hinson advising that the company's water supply conditions have changed materially in the last thirty days, and that the company now has an abundance of water for producing hydro energy. In consequence of this situation the company will not be in a position to use the district's unused energy until September 1, 1938, and this paragraph of the contract will no doubt have to be modified accordingly.

A temporary connection between one of the Metropolitan Water District's generating units and the Edison Company's bank of transformers will be required in order to deliver power to the company prior to the date when the first of the Edison Company's generating units is ready for operation. This temporary connection will consist of heavy copper cables across the tailrace of the power plant, and it will cost several thousand dollars. It is believed that there should be a provision in the contract under which the company agrees to bear the entire cost of this temporary connection.

Thereafter petitioner wrote the following letter to the chief engineer of the Bureau of Reclamation on or about March 11, 1938:

Reference is made to your letter of March 1, 1938, pertaining to the temporary connection between the Metropolitan Water District and Edison Company's line at the Boulder power plant.

We have discussed the matter with the Metropolitan Water District, also reviewed general load and the overabundant water condition of our hydro supply. It now appears that unless some unforeseen emergency arises that we will not have use for energy from Boulder until our own unit is ready for service. If an emergency should arise we could make the connection on the high side of the Metropolitan transformers with comparatively short notice and operate at reduced voltage, and without Peterson coil; therefore, unless so instructed by us you should defer any further plans for the temporary connection.

On or about September 17, 1938, the Commissioner of Reclamation wrote as follows to the Secretary of the Interior:

The proposed rate of one-half mill per kilowatt-hour, although covering firm power, is satisfactory to the District which is chiefly concerned with the rate since the revenue becomes a credit on the District's obligation to the United States. It should be noted, in this connection, that the City of Los Angeles is to have the right to an amount of unused District energy equal to that taken by the Southern California Edison Company and at the one-half mill rate under this contract, but that there is preserved to the United States the right as provided in existing contracts to sell to other parties such energy as is not taken by the City of Los Angeles and the Southern California Edison Company under the attached contract. It is expected under this arrangement that there will be unused District energy available for sale to others during the life of this contract.

The District is especially interested in the early execution of this contract because it is to become the basis of a further agreement between the District and the Southern California Edison Company relating to furnishing of power needed by the District for its construction program. The arrangement is considered a very satisfactory one to the District.

Thereafter a contract was entered into, on October 14, 1938, between petitioner and the United States, for the sale to petitioner of Boulder power allocated to the Water District. This is the "interim contract" referred to above as the contract under which petitioner began to take Boulder power prior to the date on which it was obligated to do so under its contract of April 26, 1930. This interim contract contained the following recitals:

6. WHEREAS, the District will be unable for a period of years from and after the date when it is required to take and/or pay for firm energy * * * to use a portion of such energy for the only purpose for which energy has been allocated to and purchased by the District, namely for pumping water into and in its aqueduct, and has requested the Secretary to dispose of such excess energy * * * and

7. WHEREAS, the Company has made application to the Secretary for the resale to it for the term of this contract of a part of the firm energy contracted for by the District, but which will not be required, temporarily, for pumping water into and in the aforesaid aqueduct;

The contract then provided:

the United States agrees that, of the firm energy to be developed at Boulder Dam power plant and heretofore allocated to and contracted for by the District, the Company [petitioner] shall have the right to take, for a period beginning on the date when generating equipment leased by said Company * * * is installed by the United States and ready for operation, and ending on the date when energy becomes available to the Company under said contract [of April 26, 1930, between the United States and the City and petitioner] * * * 50,000,000 kilowatt hours, plus such additional amount as may be desired by the Company and from time to time during the period of this contract may remain unsold, available, and unused by the District; * * *

* * * *

In consideration of this contract, the Company agrees to pay the United States, for credit to the District, for the use of falling water for generation of energy by the Company under this contract at the rate of one-half mill ($ 0.0005) per kilowatt-hour (delivered at transmission voltage).

The contract further provided that the power sold to petitioner under its terms was to be generated by "the machinery, equipment and facilities leased by the Company under the aforesaid lease-contract of April 26, 1930, as amended * * *."

At about the time this interim contract was entered into, the City of Los Angeles gave its written consent thereto, so that this firm energy could be sold to petitioner at the rate stated above, which was lower than the contract rate for firm energy to be sold to petitioner, as theretofore agreed.

During the year 1939, petitioner received through its own facilities 566,903,000 kilowatt-hours of energy from Boulder Dam, for which it paid $ 283,451.60, at the rate of one-half mill per kilowatt-hour. However, this power was treated as the unused power of the Water District, and payment made therefor by petitioner to the Bureau of Reclamation was credited by the latter to the account of the Water District. The following table shows the Water District's obligation for kilowatt-hours, the amounts used by said District, the amounts resold and the amounts unused and not resold:

Operating year ending May 31	Obligation	Used by MWD
1939	768,959,524	42,848,400
1940	1,045,414,242	227,368,669
1941	1,270,861,054	143,064,984
1942	1,495,380,088	44,017,660
1943	1,510,958,365	60,037,059
1944	1,507,870,316	82,247,841
1945	1,504,782,268	91,709,305
1946	1,501,694,219	123,081,428
1947	1,498,606,170	133,567,956
1948	1,495,518,121	293,060,715
1949	1,492,430,072	322,377,526
1950	1,489,342,023	356,573,150
Total	16,581,816,462	1,919,954,693

		Unused and
Operating year ending May 31	Total resales	not resold
1939	15,386,300	710,724,824
1940	775,245,828	42,799,745
1941	455,330,619	672,465,451
1942	582,078,397	869,284,031
1943	1,450,921,306
1944	1,425,622,475
1945	1,413,072,963
1946	1,378,612,791
1947	1,365,038,214
1948	1,202,457,406
1949	1,170,052,546
1950	1,132,768,873
Total	12,366,587,718	2,295,274,051

Under petitioner's contract of April 26, 1930, power taken from Boulder Dam by the States of Arizona and Nevada reduced the quantity of power petitioner was obligated to take. At that time it was anticipated that these states would not use any substantial quantities of Boulder energy, and in fact the State of Arizona used none through 1948. Due to the building of a magnesium plant in Nevada for war-time needs, that state used some Boulder energy.

The following table shows petitioner's commitment to take Boulder firm energy if Arizona and Nevada used no Boulder energy, and petitioner's commitment as reduced because of the energy used by Nevada:

	Per cent of
Fiscal year ending May 31	petitioner's	KWH if none	KWH as
	full commitment	taken by the	reduced
		states
1941	55	500,654,829	491,500,104
1942	70	635,900,073	619,360,149
1943	85	770,589,468	740,661,821
1944	100	904,723,014	800,792,378

The following table shows the amounts of firm power required to be taken by petitioner from Boulder under the Boulder Canyon Project Adjustment Act (enacted July 19, 1940) and regulations issued May 20, 1941, which amounts were actually taken, for the following fiscal years ending May 31:

	Firm power
	commitment
Year	KWH
1941	491,499,175
1942	610,615,369
1943	727,031,459
1944	786,043,425
1945	751,018,965
1946	838,037,518

The following table shows the total kilowatt-hours of energy, both firm and secondary, taken by petitioner from Boulder for the calendar years 1939 through 1945:

Calendar	Total KWH taken
year	from Boulder
1939	1 566,903,200
1940	2 683,104,430
1941	637,542,800
1942	1,052,237,500
1943	1,355,916,400
1944	1,888,887,200
1945	1,755,546,719

Petitioner had a "management committee," which met informally each week to provide information to various levels of management as to petitioner's activities. The "committee" consisted of the executive committee of petitioner's board of directors, its officers, and the heads and assistant heads of its departments. Minutes were not taken at these meetings, but after each such meeting a report concerning the meeting was prepared and circulated among persons in petitioner's organization concerned with its management.

The following editorial appeared in a newspaper called the Fresno Bee, on September 28, 1939:

Great power projects such as Boulder Dam have the capacity for performing a valuable service in years when water is low in the mountain reservoirs.

The eighth of the great 82,500 kilowatt-ampere generators has just been put into operation and its output placed on the line of the SOUTHERN CALIFORNIA EDISON COMPANY. This unit was hurried to completion at the request of the company because it could not supply its own customers with an adequate supply of electricity.

This makes almost a million horsepower of energy available at the big dam.

A total of 239,371,000 kilowatt-hours was produced at the plant last month.

The private companies, with all their resources, cannot produce electricity on a scale big enough to compete successfully with the federal government.

Thereafter, the report of petitioner's management committee, dated October 27, 1939, stated as follows:

ADVENT EDISON BOULDER POWER -- PUBLICITY POWER SHORTAGE

The figures prepared by our Operating Department show conclusively that the press report to the effect that the Boulder power supply averted a shortage on our system was erroneous. For instance, the total delivery on the system was 3,160,000,000 kilowatt hours. Including Pacific Gas & Electric delivery it amounted to 3,560,000,000. The total resources available, exclusive of Boulder, amounted to 5,065,000,000 kilowatt hours. The capacity available was 940,000 kilowatts. The peak demand 500,000 kilowatts. After including Pacific Gas & Electric, the peak was 650,000 kilowatts.

Petitioner issued annual reports to its stockholders. These reports, so far as they have been introduced in evidence, are incorporated herein by this reference.

It was common for petitioner, and for the industry to which it belonged, to examine its future load requirements and its productive capacity for meeting those requirements, and to make plans and take steps to assure sufficient productive capacity in the future. The studies made in 1936, above referred to, were an example of this process of planning and preparation. Petitioner's management was alert, competent and experienced, and was qualified to estimate its future needs and to take the measures necessary to provide for those needs.

Prior to and during the base period years, petitioner had examined its needs for future productive capacity. In estimating its needs for the base period years, petitioner assumed water conditions to be about the same as those of 1931, an exceptionally dry year. Petitioner considered that the demand for its power during the base period could be met without additional productive capacity beyond that available through the productive facilities it already had, together with the power that would become available to it through Boulder Dam.

Prior to the base period and in or about 1931 petitioner had begun construction of an additional producing unit at one of its steam plants. That additional unit was never built, and failure to complete it was due at least in part to the anticipated advent of power from Boulder Dam. During the period from 1928 to 1945, petitioner undertook no construction, other than the start made on the foregoing unit, of additional generating capacity. From 1928 to 1939, petitioner waited for Boulder power to become available.

The generators at Boulder Dam, ordered by petitioner in January 1937 and installed in June and September 1939, could have been ordered by petitioner earlier and would have been available for petitioner's use earlier. Petitioner had within its control the time of placing of its orders for those generators, so that it could have accelerated their receipt or delayed their installation. Petitioner did not put in its orders for those generators sooner because it did not regard itself as needing them sooner. Petitioner did not need those generators at least until it "had gone through the correction period of recovering from the capacity, which was freed by the loss of the cities in 1936 and 1937."

Construction by petitioner of an additional steam unit, providing an additional 50,000 to 100,000 kilowatts, would have taken about 2 years. Construction of a major hydroelectric station would have taken about twice as long. Construction of such facilities is preceded by a period of planning, and time must be allowed for placing orders and for delivery of the machinery or equipment. Purchase and installation of a generator with a capacity of 82,500 kilowatts could reasonably be expected to be completed at Boulder Dam within about 2 years from the time petitioner gave notice that it wanted such a generator.

The systems of the Water District, the City of Los Angeles, and P G and E generated power at "60 cycles." Petitioner, for the most part, generated power at "50 cycles." In order for petitioner to take power from those other systems, it was necessary to install equipment which would allow for such interchange and would convert the power into the required number of cycles. Such interchange equipment permitted an exchange of power in either direction -- either to or from petitioner. Such equipment was installed, enabling interchange of power between petitioner's system and the systems of the Water District, the City of Los Angeles, and P G and E. Petitioner could have obtained power during the base period from one or more of these systems.

Petitioner's Sales and Sales Policies.

Petitioner maintains a sales department, one of the functions of which is to plan for the sale of electric energy. During the base period plans for sales programs were submitted to petitioner's management for approval. Certain of those plans were adopted and put into effect; others, however, were not adopted. Failure to put any of these plans into effect during the base period was not due to a shortage or anticipated shortage on petitioner's part of electric power for sale.

Petitioner might use a variety of techniques in its sales programs.

It might engage in educational activity which would result in an increased demand for electricity at some time in the future, as in persuading architects and builders to provide sufficient facilities for use of electricity in homes, stores, and factories. Petitioner might promote the sale and use of appliances such as electric ranges, irons, washers, etc., which would cause a more immediate increase in demand for electricity. Petitioner might sell to customers whose demands were for power at "off-peak" times; and there were some customers (such as another utility) to whom it might sell a specific rather than an indefinite quantity of power. In many of these areas, petitioner was not the only factor operating to influence sales; for example, sales of appliances were affected by the efforts of appliance manufacturers and retailers.

In 1933 petitioner tried a plan to promote use of electric ranges. Petitioner leased the range to the customer at a rental of $ 1.50 per month; ⁵ subsequently, the customer was offered an incentive to trade the range in on a new range to be purchased from an appliance dealer. Such rental ranges were offered to customers under this plan only on a single day in 1933, and the plan was not thereafter used by petitioner during or prior to the years here in issue. Sustained sale of appliances by petitioner conflicted with the interests of appliance dealers. Failure by petitioner to try that plan again was not due, during the base period years, to any lack or anticipated lack by petitioner of sufficient electric power for sale during those years.

In the area served by petitioner, there were gasoline engines in use for agricultural purposes. Petitioner was constantly endeavoring to have these engines replaced by ones using electric power. In order to attain such replacement, petitioner bought up some of these engines and shipped them to localities outside its service area. Petitioner's effort during the base period years to have these engines replaced was not substantially different from its effort for the same purpose during years prior to the base period. Inability or anticipated inability on petitioner's part to supply power to customers who could change to electric engines was not responsible, during the base period years, for any relaxation in the effort to achieve substitution of such engines for gasoline engines.

From time to time petitioner engaged in activity to promote the sale of electric refrigerators. Besides petitioner's efforts in this direction, the sale of refrigerators, as well as other appliances, was promoted by manufacturers and dealers, and petitioner had no control over the promotion efforts from these other sources. During the base period years petitioner did not reduce its efforts to promote sales of electric refrigerators because of any shortage or anticipated shortage of electric power.

Petitioner's customers included industrial and commercial establishments. During the base period years, petitioner did not refrain from making sales to such establishments, or from encouraging their increased use of electricity for various purposes, because of any insufficiency or anticipated insufficiency of power resources.

In the area serviced by petitioner, there were other forms of energy which competed with electricity as a source of power. Wells in or near that area provided cheap natural gas and oil, which were used as a source of energy. In some instances, steam also competed as a source of power. Competition from these other sources limited the quantity of new business petitioner was able to obtain during the base period, and was an important factor in "holding down the use of electricity" for various purposes.

During the base period petitioner made wholesale sales, or sales to purchasers who in turn resold the purchased power. Such sales, to municipalities and privately owned utilities, were less profitable to petitioner than retail sales or sales made to purchasers who consumed or used the purchased power. The price received for wholesale sales was "very low with only a narrow margin above cost of the generation and transmission." Petitioner would not have made these wholesale sales if, as a result, it would have had to sacrifice any appreciable quantity of retail sales.

Taking into account power which became available to it from Boulder Dam, upon which petitioner reasonably relied, there was no time during the base period at which petitioner had insufficient power to meet the maximum demands made on it, apart from the possible loss of a sale of an unusually large block of power based upon 100,000 kilowatts beginning in December 1938 to the City of Los Angeles. Apart from possible loss of the same sale, insufficient power, actual or anticipated, was not a factor during the base period which limited petitioner's sales, and was not responsible for rejection of any customers by petitioner or for an omission on its part to obtain customers which were otherwise available to it.

For the indicated years, petitioner's kilowatt-hour sales, gross operating revenue, and net income were as follows:

	Kilowatt-hour	Gross operating
Year	sales	revenue	Net income
1936	2,807,136,681	$ 41,274,000.20	$ 10,923,942.47
1937	2,475,877,423	41,276,811.73	9,740,242.27
1938	2,391,933,659	42,010,232.65	10,315,175.63
1939	2,963,269,968	44,806,062.81	1 15,608,862.91
1940	2,909,241,637	45,352,636.19	2 4,147,089.23
1941	3,339,644,348	47,563,069.47	16,887,434.15
1942	4,011,544,327	52,196,521.64	21,320,726.95
1943	4,432,058,770	54,977,943.44	23,214,757.60
1944	4,868,259.692	62,803,860.48	27,371,699.18
1945	4,709,523,897	66,374,708.81	29,319,627.53

Prior to the advent of Boulder power, petitioner, over the 10-year period 1926-1935, inclusive, had maintained a fairly constant relationship in kilowatt-hour sales as compared with its industry, both nationally and in the State of California. Its relation to national kilowatt-hour sales prior to the base period is shown in the following table:

Kilowatt-hour Sales
(Thousands)
	National	Petitioner	Petitioner's
Year					sales as
					percentage
	Sales	Index	Sales	Index	of National
1926	56,089,370	72	1,762,817	70	3.14
1927	61,251,119	79	1,874,645	75	3.06
1928	66,987,950	86	2,212,757	88	3.30
1929	75,294,467	97	2,587,642	103	3.44
1930	74,906,092	97	2,611,746	104	3.49
1931	71,901,882	93	2,541,807	101	3.54
1932	63,710,792	82	2,283,671	91	3.58
1933	65,915,703	85	2,228,190	89	3.38
1934	71,081,598	92	2,393,270	95	3.37
1935	77,596,025	100	2,513,162	100	3.24
Ten-year average					3.35

If petitioner had continued to maintain its 10-year average relationship with the industry, its kilowatt-hour sales during the base period would have been as follows:

	National
Year	KWH sales		Petitioner's
	(000 omitted)		KWH sales
1936	90,044,265	X 3.35	3,016,482,878
1937	99,358,791	X 3.35	3,328,519,499
1938	93,731,327	X 3.35	3,139,999,455
1939	105,767,509	X 3.35	3,543,211,552

Petitioner's sales in comparison with national sales during the base period were as follows:

	National	Petitioner
					Per cent
Year					of
	KWH sales	Index		Index	national
	(000 omitted)	1936 = 100	KWH sales	1936 = 100
1936	90,044,265	100	2,807,136,681	100	3.10
1937	99,358,791	110	2,475,877,423	88	2.49
1938	93,731,327	104	2,391,933,659	85	2.55
1939	105,767,509	117	2,963,269,968	106	2.80

Petitioner's earnings during the base period in comparison with national earnings were as follows:

	National	Petitioner
Year			Excess profits
	1 Net income	Index	net	Index
			1 income
	(000,000)		(000)
1936	$ 1,069	100.0	$ 27,566	100.0
1937	1,111	103.9	26,459	96.0
1938	1,109	103.7	27,775	100.8
1939	1,211	113.3	29,276	106.2

Reduction of Interest Charges.

Petitioner's long-term indebtedness on January 1, 1936, amounted to $ 173,850,000. By December 31, 1939, this indebtedness had been reduced to $ 142,273,000 as a result of retirements at various times during the base period years, decreasing that indebtedness by $ 31,577,000; and thereby, between the beginning and the end of the base period, annual interest charges were reduced by the amount of $ 936,592.

On or about September 1, 1939, petitioner issued bonds for cash in the face amount of $ 30,000,000 and designated "3 1/4's of 64." The proceeds were used to retire, on September 1, 1939, an outstanding $ 30,000,000 bond issue designated "4's of 60." The effective interest rate and amortization on the bonds thus retired had been 4.017 per cent, amounting to $ 1,205,074.64 annually. The new bonds carried an effective interest rate of 3.09 per cent, amounting to $ 927,382.47 annually. For years after 1939 and in comparison with the years 1936 through 1938, this resulted in an annual saving of $ 277,692.17; for 1939, when each bond issue was outstanding for part of the year, the saving was $ 92,564.04 over the prior year.

Petitioner also had long-term indebtedness outstanding represented by bonds designated "3 3/4's of 60," in the face amount of $ 108,000,000. The effective interest rate on these bonds was 4.004 per cent, or $ 4,324,547 annually. These bonds required a premium, for their redemption prior to maturity, in a decreasing amount depending upon the year of redemption. The call price prior to and during the calendar year 1940 was 107 1/2 per cent, which dropped to 105 per cent if called during any calendar year thereafter through 1950. These bonds were called for redemption and were retired on January 1, 1941, at 105 per cent. This retirement was effected with the proceeds derived from the sale, on or about October 9, 1940, of bonds in the face amount of $ 108,000,000 and designated "3's of 65."

Depreciation Deductions.

Deductions for depreciation were allowed petitioner by respondent for the base period years as follows:

Year	Depreciation allowed
1936	$ 9,828,787
1937	9,898,165
1938	10,026,428
1939	8,449,334

Depreciation for the year 1939 was reduced by respondent, upon audit of petitioner's tax returns, by the amount of $ 1,809,000. Of this amount, $ 1,695,000 was due to respondent's reduction in the rates of depreciation on the assets in many of petitioner's capital accounts. This reduction was based generally upon Bureau Bulletin F, revised January 1942. The rates as thus reduced were applied in computing petitioner's depreciation for the subsequent years through 1945. If these reduced rates had been used in computing depreciation for the years 1936, 1937, and 1938, the depreciation for those years would have amounted to $ 8,176,602.05, $ 8,231,490.42, and $ 8,341,392.75, respectively, and depreciation for those years would have been reduced by $ 1,652,184.95, $ 1,666,674.58, and $ 1,685,035.25, respectively.

Petitioner's Tax Liability.

On or before the dates required by law, petitioner filed its Federal income and excess profits tax returns for the years 1942 through 1945, and paid excess profits and income taxes as follows:

	Excess profits
Year	tax	Income tax	Total
1942	$ 2,591,709.71	$ 6,639,649.94	$ 9,231,359.65
1943	9,002,668.01	4,527,773.40	13,530,441.41
1944	12,093,847.07	4,519,242.85	16,613,089.92
1945	13,650,519.07	4,518,711.99	18,169,231.06
Total	$ 37,338,743.86	$ 20,205,378.18	$ 57,544,122.04

In computing the excess profits tax liability shown above, petitioner had the advantage of the so-called growth formula under section 713 (f) of the Internal Revenue Code, whereby the statutory average base period net income under section 713 (f) was substantially higher than the arithmetic average of petitioner's excess profits net income for the base period, as shown below:

1 Excess Profits Net Income
	For 1942	For 1943
1936	$ 11,029,482.75	$ 11,029,482.75
1937	9,902,549.92	9,963,404.65
1938	11,304,383.71	11,336,246.64
1939	14,790,248.02	14,795,134.99
Average	11,756,666.10	11,781,067.25
713 (f) Credit	14,337,965.63	14,350,314.39

1 Excess Profits Net Income
	For 1944	For 1945
1936	$ 11,029,482.75	$ 11,029,482.75
1937	9,979,603.38	9,954,562.68
1938	11,308,901.83	11,189,024.64
1939	14,789,347.23	14,724,088.15
Average	11,776,833.79	11,724,289.55
713 (f) Credit	14,321,415.26	14,188,823.23

The following table shows petitioner's income after Federal taxes thereon for 1939, and its net income after taxes, including excess profits taxes, for succeeding years:

	Net income after
Year	Federal taxes
1939	$ 12,903,551
1940	3,154,986
1941	11,821,774
1942	12,089,367
1943	9,684,317
1944	10,758,609
1945	11,150,397

Petitioner filed timely applications for relief under section 722, I. R. C., for the years 1942, 1943, 1944, and 1945. In these applications petitioner asserted constructive average base period net income (CABPNI) and asked for refunds of excess profits taxes as follows:

Year involved	CABPNI	Refund asked
1942	$ 17,550,233.99	$ 1,943,782.29
1943	17,372,808.14	3,853,318.47
1944	17,367,309.77	3,560,656.67
1945	17,306,925.02	3,614,890.50

In these applications under section 722, petitioner asserted the following facts as the basis of its claim for relief: (1) "Taxpayer lost three large wholesale customers in the latter part of 1936 and the early part of 1937 and the normal growth of taxpayer's business did not compensate for this loss until after the close of the base period." (2) "Taxpayer sold in July, 1939, a substantial amount of its business to the City of Los Angeles, under threat of condemnation. The business thus lost was not recovered by Taxpayer by normal growth until after the close of the base period years." (3) "Taxpayer has been receiving, since June, 1939, large quantities of electric power from Boulder Dam. Revenues from the sale of this power only appear in one year of the base period." (4) "Income during the base period years is understated because of high interest charges. During the base period years, Taxpayer engaged in a series of refinancing operations in order to reduce interest charges, the full effect of which is reflected in 1941 and subsequent years." (5) "Taxpayer's depreciation rates were lowered in 1939 by the Treasury Department. Taxpayer's depreciation deduction for 1936, 1937, and 1938 should be adjusted to a comparable basis for the purpose of computing the excess profits credit."

In Docket No. 6903, respondent mailed a notice to petitioner dated October 21, 1944, which inter alia determined a deficiency in excess profits tax for 1942 and rejected petitioner's 722 claim respecting that year. In Docket No. 38498, respondent mailed a notice to petitioner dated December 7, 1951, which rejected petitioner's 722 claims respecting 1943 and 1944, pursuant to section 732, I. R. C., but which did not determine any deficiencies in tax for those years pursuant to section 272, I. R. C. In Docket No. 38499, respondent mailed a notice to petitioner, dated December 7, 1951, in which petitioner's 722 claim for 1945 was rejected pursuant to section 732, I. R. C.

Respondent found that petitioner had a commitment, under section 722(b) (4) of the Internal Revenue Code, for increased capacity for production because of its contract for Boulder power. However, respondent ruled that petitioner had not established that its average base period net income, computed under section 713 (f) of the Internal Revenue Code, was an inadequate standard of normal earnings.

Petitioner increased its capacity for production or operation during the base period and there was an increase in its capacity for production or operation consummated during the taxable years as a result of a course of action to which petitioner was committed prior to January 1, 1940.

Petitioner's average base period net income is an inadequate standard of normal earnings, and a fair and just amount representing normal earnings to be used by petitioner as a constructive average base period net income is an amount equal to $ 1,200,000 more than petitioner's average base period net income otherwise determined without the benefit of section 722 of the Internal Revenue Code.

OPINION.

In these proceedings petitioner appeals from respondent's denials in toto of its applications for excess profits tax relief under section 722 of the Internal Revenue Code⁶ for the years 1942, 1943, 1944, and 1945.

Petitioner was organized in 1909 under California law, and during the intervening years has been engaged as a public utility in generating, transmitting, and distributing electric energy in southern California to domestic, industrial, commercial, and municipal purchasers. Its facilities for generating electricity were in part hydroelectric, or operated by waterpower, and in part were powered by steam. In the conduct of its business, petitioner was subject to regulation by the state utilities commission.

The Boulder Canyon Project Act became law on December 21, 1928. It provided for the construction of Boulder Dam, and authorized an appropriation of $ 165,000,000 for that purpose, with a prohibition against use of such funds until the Secretary of the Interior had in effect made suitable contractual provision for repayment to the United States within 50 years of all costs and expenses incurred. Such contracts were in fact executed on April 26, 1930, petitioner being a party to one of them. The power to be generated at Boulder was allocated by the United States not only to the Metropolitan Water District but also to petitioner and other named allottees, including the City of Los Angeles, which operated a municipally owned system for the distribution and sale of electricity. Work on the dam was thereafter promptly commenced, and by 1935 it was ready to start impounding water. The first generator went into full operation in October 1936; by that time the City had completed a transmission line to Boulder, and began to receive the power thus generated.

The City had previously obtained its power from petitioner, and it was recognized at the time the 1930 contracts were executed that, when the City began to take power from Boulder, petitioner as a consequence would have surplus power on its hands; petitioner was accordingly allowed in substance a period of three additional years within which to recoup its lost business before being required to take its share of Boulder power. Although the City actually began to receive Boulder power in 1936, it was not obligated to do so under its contract until June 1, 1937; and, accordingly, petitioner was not required to take its share of Boulder power prior to June 1, 1940.

The advent of Boulder power plays a dual role in petitioner's claim to relief under section 722. On the one hand, petitioner lost Los Angeles and two other cities (Burbank and Glendale) as customers relatively early in the base period as a consequence of Boulder; it contends that its business during the base period was depressed by reason of that fact, and it seeks relief under section 722 (b) (1) and (b) (2). On the other hand, petitioner had committed itself by contract in 1930 to take power from Boulder, which power it actually received and sold during the taxable years; it contends that normal earnings from such power were not reflected in its average base period net income, and it seeks relief on that account under section 722 (b) (4). Two additional grounds for relief are unrelated to the foregoing; they grow out of certain deductions for depreciation and interest, and are asserted under section 722 (b) (5).

I

Loss of the Three Cities -- Section 722 (b) (1) and (b) (2).

The territory served by petitioner included the cities of Los Angeles, Burbank, and Glendale, and prior to 1918 petitioner sold electricity at retail to consumers in those cities. Thereafter each of those cities acquired petitioner's distribution facilities located within it. But petitioner's sales in respect of those cities did not cease; from 1923 through 1936 the cities bought electricity from petitioner at wholesale for redistribution through their municipally owned systems.

The electricity to be generated at Boulder Dam was allocated in part to these cities in 1930. In 1936, when facilities were completed for generating and transmitting Boulder power to the City of Los Angeles, it ceased most of its purchases from petitioner; however, petitioner did continue to sell some power to the City and in addition received an annual rental of $ 575,000 for the lease of a 60,000 kilowatt steam plant to the City for each of the years 1937 through 1947. The cities of Burbank and Glendale similarly discontinued the greater part of their wholesale purchases from petitioner in 1937, when they began to receive Boulder power. ⁷ As noted above, it was contemplated that the productive capacity of petitioner that would be freed because of the shift by these cities (particularly Los Angeles) from petitioner's power to Boulder power, would be in such quantity that it would take up to 3 years to find other purchasers for such power, and it was for this reason that petitioner was not required by its 1930 contract to start receiving Boulder power until 3 years after Los Angeles was obligated to do so.

On July 1, 1939, petitioner sustained a further loss of customers, sometimes referred to as "fringe customers." On that date, under threat of condemnation, petitioner sold to the City of Los Angeles that portion of its distribution system in territory which had been annexed to the City but which petitioner had served for many years. The sale resulted in a loss of 53,449 customers. As part of the same transaction, petitioner purchased certain distribution facilities located outside the City, thereby acquiring 9,745 customers formerly served by the City. The end result of the transaction to petitioner was a net loss of 43,704 customers and approximately $ 1,500,000 in annual revenues.

The loss of the cities' business and the lag in replacing it, and the loss of the fringe customers, are asserted by petitioner to entitle it to relief under subsections (b) (1) and (b) (2). We agree that petitioner meets the requirements of at least one of these provisions.

To come within (b) (1), the average base period net income must be an inadequate standard of normal earnings because during base period years "normal production, output or operation was interrupted or diminished because of the occurrence * * * of events unusual and peculiar in the experience" of the taxpayer. Under (b) (2), so far as it applies here, it is required that the average base period net income be an inadequate standard of normal earnings because during the base period the taxpayer's business "was depressed because of temporary economic circumstances unusual in the case of such taxpayer * * *." In general, (b) (1) deals with physical events which produce the required consequences, whereas (b) (2) deals with economic events which cause the consequences involved. Cf. H. Rept. No. 146, 77th Cong., 1st Sess., p. 12; S. Rept. No. 75, 77th Cong., 1st Sess., p. 12; H. Rept. No. 2333, 77th Cong., 1st Sess., p. 143; Treasury Regulations 112, section 35.722-3 (a); ⁸Matheson Co., 16 T. C. 478, 486; Granite Construction Co., 163">19 T. C. 163, 169. Petitioner argues that (b) (1) is applicable because the loss of the cities, which appears to be an economic event, was caused by construction of Boulder Dam, alleged to be a physical event sufficient to result in compliance with (b) (1). However, it is unnecessary to rule on the question, since petitioner relies on the same circumstances for relief under both (b) (1) and (b) (2), and has available to it under the latter all the relief to which it might be entitled under the former. ⁹

We examine, therefore, the claim for relief as made under (b) (2). Respondent objects, first, that the loss of the cities' business and of the fringe customers was not unusual for petitioner, in that since 1918 petitioner had lost business because of municipal operation of power systems. Our findings make it clear, however, that the loss of business, incurred in 1936 and 1937 because of the cities' transfer to Boulder power, was so great that it was surpassed only by the loss incurred by petitioner in or about 1918 when it had to dispose of its distribution facilities in Los Angeles under threat of condemnation. While it is true that petitioner did lose customers to municipally operated power systems during a number of years prior to 1936, such losses were small in comparison with the losses of 1936 and 1937. Somewhat the same observation may be made about the net loss in fringe customers in 1939; this resulted in a loss of annual gross revenue amounting to about $ 1,500,000, and the record fails to show any prior losses at least since 1919 even remotely approximating this magnitude.

The (b) (2) requirement that the temporary economic circumstances be "unusual" is comparable to the (b) (1) condition that the qualifying events be "unusual and peculiar" in the experience of the taxpayer. Certainly, (b) (1) is no less stringent in this connection than (b) (2). And we think that the meaning of this condition has been correctly explained in the Bulletin on Section 722 (p. 11):

Cases involving this question may be classified into three groups. First, there will be those cases in which section 722 (b) (1) is clearly applicable because the event has never before been encountered by the taxpayer or has happened at such infrequent intervals that its occurrence during the base period constitutes a clear distortion of average base period net income. At the other extreme will be those cases in which section 722 (b) (1) is not applicable because the event is an ordinary and expected hazard of the business, occurring with such frequency that its presence is to be expected in any 4-year period. Between these two extremes will be those cases in which the event is not unique in the taxpayer's experience but has occurred with such frequency or severity during the base period as to render the actual average base period net income an inadequate standard of normal earnings.

If the event causing the interruption was of such severity or duration as to constitute it a different kind of event, section 722 (b) (1) should be considered applicable. * * *

The record makes it plain to us that the loss of the 3 cities in 1936 and 1937 and the loss of the fringe customers in 1939 were of such severity that they were "unusual" within the meaning of the statutory provisions.

Respondent further objects that (b) (2) is inapplicable because the loss was not "temporary." He points to the fact that to the extent that the cities undertook to buy their power at Boulder they were lost permanently as customers of petitioner. Petitioner argues, however, that "the question is not whether a particular customer is lost forever; rather, the issue is whether the taxpayer's earning capacity is permanently decreased by the loss of the customer or whether such earning capacity can be replaced by sales to others." In this connection, petitioner reminds us that the very reason it was not required to begin to take its own share of Boulder power until 3 years after the shift of Los Angeles to Boulder power was to enable it to replace the lost load by increasing its sales to others without being burdened meanwhile by excess capacity attributable to Boulder.

We think that respondent's contention takes an unduly narrow view of (b) (2), and that the petitioner's position is more in accord with the basic purpose of the statute. Indeed, section 35.722-3 (b) of Regulations 112, after discussing the meaning of the word "temporary," provides an example which goes far to sustain petitioner's position:

An example * * * might be a taxpayer which for a long period of years conducted business with one customer which it lost during the base period because such customer decided to manufacture for itself the product it had formerly bought from the taxpayer. The taxpayer would be compelled to develop a new market. The average earnings of the taxpayer for the period of time during which the taxpayer was engaged in obtaining new customers would not represent an adequate standard of its normal earnings and would be sufficient cause for the establishment of a constructive average base period net income under section 722.

This example also appears in the committee reports which considered the bill that became the Revenue Act of 1942. See H. Rept. No. 2333, 77th Cong., 1st Sess., p. 143; S. Rept. No. 1631, 77th Cong., 1st Sess., p. 199. In the circumstances, we accept it as a correct interpretation of the statute, and we are unable to see any significant distinction between the example and the case at bar. We hold that the loss of the 3 cities and the fringe customers are within the provisions of (b) (2).

In making correction for the depression in petitioner's earnings during the base period by reason of its loss of the 3 cities and the fringe customers, certain limiting considerations must be given effect. In the first place, petitioner did continue to sell some power in relatively small quantities to the 3 cities even after their shift to Boulder; therefore, an adjustment must be made for such sales, as well as for the $ 575,000 annual rental which petitioner received from Los Angeles by reason of the lease of the 60,000-kilowatt steam plant.

Secondly, petitioner's lost sales to the 3 cities were sales at wholesale. Respondent argues that petitioner did not make any profit on such sales and indeed lost money on them. We cannot agree with respondent, and are satisfied on the record that such sales were profitable. However, we are also satisfied that they were far less profitable than sales which petitioner made to other customers, particularly retail consumers. Accordingly, the fact that such sales were among the least profitable of all of petitioner's sales must be taken into account in correcting the abnormality caused by the loss of the 3 cities.

Thirdly, the record convinces us that the loss occasioned by the shift of the 3 cities to Boulder power was fully recouped by the middle of 1939, and that there was partial and steadily growing recoupment between 1937 and the middle of 1939. Consequently, an appropriate adjustment must be made for this fact. To be sure, petitioner argues that in determining relief we must proceed as though the cities had not been lost at all, and that the growth that it otherwise enjoyed is to be superimposed over the earnings from the cities which it lost. And indeed there are general statements in the regulations and the Bulletin on Section 722 to the effect that the qualifying events should be eliminated so that net income for the base period may be computed as though such events had not occurred. ¹⁰ But the difficulty in applying those general statements in the context of this case is that the growth which petitioner attained between 1937 and the middle of 1939 was pro tanto regarded merely as a replacement for the business of the cities which it lost. Otherwise, petitioner could not have qualified for relief under (b) (2) at all, since the loss would not have been a temporary one, as required by the statute. Petitioner cannot have it both ways. If, in order to qualify under (b) (2), it establishes that the increase in sales to others after the cities' shift to Boulder power was merely a replacement of the cities' business and that it therefore satisfies the "temporary" requirement, it cannot at the same time successfully maintain that such increase in sales would have occurred anyhow and that it is entitled to a reconstruction that assumes not only the continuance of the cities as customers but also the growth that was regarded as replacing the loss of the cities. Petitioner's relief in this connection must be measured by the conditions which entitle it to relief in the first place.

Fourthly, in eliminating the abnormality caused by the loss of approximately $ 1,500,000 in annual revenues from the fringe customers, we must take into account that the loss occurred on July 1, 1939, and that only the earnings for the second half of 1939 require correction as to this factor. However, the sales which petitioner thus lost were in large part to retail customers, its most profitable type of business, and in adjusting petitioner's earnings for the loss of the fringe customers we must give it the benefit of this fact.

II

Increased Capacity as a Result of Commitment to Take Boulder Power -- Section 722 (b) (4).

As a further basis for relief petitioner contends that by reason of its 1930 contract it was committed to begin taking Boulder power on June 1, 1940, and that normal earnings from such increased capacity were not reflected in its average base period net income. It relies upon section 722 (b) (4).

In so far as those provisions apply here, a taxpayer qualifies for relief under (b) (4) where it is shown that its average base period net income is "an inadequate standard of normal earnings" because the taxpayer "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." A change in the character of the business is defined to include "a difference in the capacity for production or operation," and is required to take place during or immediately prior to the base period; however, if such a change is "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," it is "deemed to be a change on December 31, 1939." Moreover, in its so-called push-back rule, (b) (4) provides that "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 made the change in the character of the business two years before it did so, it shall be deemed to have * * * made the change at such earlier time." Where the taxpayer shows that it otherwise complies with the statute, it must also establish, to be entitled to relief, a constructive average base period net income to be used in lieu of its average base period net income computed without the benefit of section 722.

The parties are agreed that petitioner "did have a valid commitment under Section 722 (b) (4) of the Internal Revenue Code for increased capacity for production because of its contract for Boulder power," and there is no dispute that a requisite change within (b) (4) occurred. However, respondent's principal contention, in contesting petitioner's claim to relief under (b) (4), is that the additional capacity represented by petitioner's commitment for Boulder power would not in fact have resulted in additional earnings had it been available during the base period, and that therefore the commitment did not render petitioner's average base period net income an inadequate standard of normal earnings.

1. We are met at the outset of this point with a sharp disagreement between the parties as to the scope of relief provided by (b) (4). Petitioner argues, in substance, that in commitment cases effect must be given to additional earnings which the taxpayer normally might expect to derive in years following the base period as a result of the change consummated after the base period. Its position is that a projection is to be made "as of" the end of the base period, of the additional earnings that it might reasonably expect in the subsequent years from the increased capacity for which it had committed itself. Petitioner refers to this approach at times as a "projective type mechanism." Respondent, on the other hand, contends that there is no warrant in the statute for such a technique, and that relief is permissible only to the extent that petitioner can show (either with or without the push-back rule) that the additional capacity would have meant increased earnings to the taxpayer during the base period or by the end of the base period.

We agree with respondent that there is no statutory justification for petitioner's "projective type mechanism," and that it is indeed contrary to the general framework and purpose of the statute. Certainly, in noncommitment (b) (4) cases it is clear that where increased capacity is the basis for relief the pivotal inquiry is whether such increased capacity would have resulted in increased earnings during the base period. Cf. National Grinding Wheel Co., 8 T. C. 1278; Green Spring Dairy, Inc., 18 T. C. 217; Schneider's Modern Bakery, Inc., 19 T.C. 763">19 T. C. 763. And we have applied the same test where the increase in capacity was attributable to a (b) (4) commitment. Studio Theatre Inc., 18 T. C. 548, 567.

The selection of the years 1936 through 1939 as the base period reflects a legislative judgment that economic conditions were generally normal at that time and that excess profits due to the war in the years which followed could be determined by comparing the earnings of the war years with those of the base period. However, Congress recognized further that there might be certain abnormalities in the base period itself, and, by section 722, it undertook to provide the means for correcting such abnormalities. But the dominant consideration that must not be overlooked is that the corrections allowed by section 722 are to be made within the framework of the base period itself. The constructive average base period net income which is authorized by the statute represents net income determined for the base period, after making the permissible adjustments for the abnormalities. Normal earnings cannot be determined in the abstract; they must be related to an economic environment. And Congress has selected the base years 1936 through 1939 as furnishing that economic environment. Petitioner's "projective type mechanism" would determine normal earnings in terms of income that might be received in post-1939 years merely because such earnings might be foreseeable as of the end of 1939. This would be wholly inconsistent with the theory underlying section 722.

Petitioner stresses the fact that it is relevant in a (b) (4) case to take into account its "prospects" as of the end of the base period. Of course, in applying the push-back rule, it may be appropriate to consider prospects as of the end of 1939 in determining what the taxpayer's level of earnings would have been at that time had it had the advantage of two years' additional experience prior to that time. But that is a far cry from saying that a constructive average base period net income may be determined on the strength of growth that was expected for the years following the base period, irrespective of whether the desired earnings would have been attainable during or by the end of the base period. Cf. Fishbeck Awning Co., 19 T.C. 773">19 T. C. 773.

In support of its position, petitioner points to the last sentence in section 722 (a), which in general forbids the use of post-1939 events in determining constructive average base period net income but, in commitment cases, provides that "regard shall be had to the change in the character of the business under section 722 (b) (4) * * * to the extent necessary to establish the normal earnings to be used as the constructive average base period net income." We find nothing in these provisions that justifies petitioner's contention. The very nature of a commitment case involves changes consummated after the base period, and of necessity one would have to consider such post-1939 events in order to make the statute effective. We need not decide here what additional post-1939 events, if any, may be taken into account, but it is clear that those post-1939 events that may be considered must be used only to the extent that they are necessary to determine "normal earnings to be used as the constructive average base period net income." (Italics supplied.) The statute contains no authorization to determine "normal earnings" generally in commitment cases, unrelated to the base period, and the legislative history of the provision fails to establish that Congress intended any such unusual result. ¹¹ In the absence of a clear indication of a contrary purpose, we cannot believe that Congress meant to exclude the influence of foreseeable post-1939 profits where a change in the business was completed in December 1939, but wanted it taken into account where the change was consummated in January 1940. Were projection of expected earnings desirable in the latter case, it would be so in the former as well; and we cannot assume that Congress acted inconsistently for these situations.

Petitioner professes to find authority for its position in the so-called variable credit rule. See Regulations 112, section 35.722-3 (d) (5). We think that rule is of no aid to petitioner. For the corrections required by the variable credit rule are merely adjustments with respect to constructive earnings that are otherwise computed with reference to the base period. The very basis for applying the variable credit rule is a determination of normal earnings in relation to base period conditions, which are then merely scaled down for the taxable year because the conditions that create the right to relief are not expected to be or are not yet in fact fully operative during the taxable year. That situation is entirely different from the present case where petitioner presses upon us a determination of "normal earnings" completely unrelated to the base period merely because, as of the end of that period, they can be foreseen as attainable in future years. The variable credit rule deals with earnings (or a portion of such earnings) which could have been realized by the taxpayer during the base period if the abnormality giving rise to relief were corrected; petitioner's "projective type mechanism," on the other hand, deals with earnings that are expected in later years. We cannot accept petitioner's "projective type mechanism" as a permissible method of determining relief under (b) (4).

2. In the alternative, petitioner contends that even if it is in error in its interpretation of the statute, discussed above, it is nevertheless entitled to relief under (b) (4) because, applying the familiar 2-year push-back rule, it would have been able to find a profitable market for the additional power that it had committed itself to take. It presented a considerable amount of evidence in an attempt to support that position.

Petitioner undertook to show that it actually lost sales or deliberately surrendered opportunities to make sales during the base period by reason of insufficient capacity. We have studied the record with great care and are satisfied that such was not the fact, apart from a possible sale of one unusually large block of power (based upon 100,000 kilowatts) to the City of Los Angeles which will be discussed separately. We are convinced that petitioner did not curtail its sales efforts during the base period, and that it did not deliberately fail to develop sales opportunities that it would otherwise have exploited.

The bulk of the evidence which bore directly on this issue consisted of the testimony of Henry C. Rice, petitioner's sales manager. Petitioner sought to show, through Rice, that during the base period, because of alleged insufficient productive capacity, it either abandoned or relaxed or refrained from instituting certain programs for stimulating sales. Rice's testimony was not convincing. He told of various "plans" for promoting sales that he submitted to petitioner's management and which, he said, were rejected. However, there was not introduced any written or documentary evidence of such "plans," their submission, or disposition.

One of these plans was said to involve the rental of electric ranges to householders at $ 1.50 a month, thereby stimulating the use of electric power. It turned out that such a program had once been tried by petitioner in 1933 for a single day. We are left with considerable doubt whether the management's refusal to proceed with that plan at a later time and its refusal to adopt other plans in which petitioner would undertake to press the sales of certain electric appliances were in any way motivated by any potential shortage of power. Other reasons for such refusals too readily suggest themselves. For example, to the extent that petitioner would sell appliances or place them in the consumer's home, it would be competing with dealers in the area, and it was important to petitioner not only to retain the good will of the dealers but also, as Rice himself recognized, "to keep our dealers alive and keep them going and keep them solvent." Moreover, manufacturers and dealers themselves promoted sales of such products, and there is no evidence in the record at all that the dealers or manufacturers in any way curtailed their own advertising or promotional efforts to sell electrical appliances. There is nothing in evidence that persuades us that, so far as the kind of activity involved in these "plans" is concerned, petitioner's conduct prior to the base period when no claim is made that it was suffering from a shortage in power, either actual or potential, was materially different from its conduct during the base period.

We cannot conclude, upon the basis of such testimony as was proffered by Rice, that petitioner deliberately curbed its efforts to increase its sales of power by reason of any alleged shortage of power. Moreover, the annual reports which petitioner made to its stockholders point strongly in the other direction.

The report for 1935, rendered March 20, 1936, called attention to the loss of the business of Los Angeles, Glendale, and Burbank, which petitioner was about to sustain, and reassured the stockholders by telling them of its "aggressive load building campaign" which was said to have been under way for more than 2 years in order to replace "this low priced wholesale business" with more profitable retail business. The report for 1936, rendered March 19, 1937, recounted the progress that was made in the "new business campaign," analyzing in some detail the company's increases in load and the sales of various energy consuming appliances in the area which it served. The report stated further:

Our intensive load-building campaign, in progress for three years, touches every activity which goes on in this vast territory. In the year 1937 it will go forward with renewed impetus, and we have reason to believe the results will exceed those of the year just closed.

The report for 1937, rendered March 18, 1938, contained no suggestion whatever of any reduced sales efforts. To the contrary, it continued the same note of optimism reflected in the prior reports, and stated that "During the year 1937 we aggressively continued our cooperative load-building campaign, which has shown substantial increases in load each year since the inauguration of the plan in the fall of 1933." This statement was followed by a quantitative breakdown of the various types of electric appliances sold in petitioner's territory, and of the increases in its load. The report also noted that the company's "promotional and sales efforts are reflected in the constant growth in the average kilowatt hour consumption by domestic consumers," which exceeded the national average, notwithstanding the company's "competition from cheap natural gas in all of our territory." The report for 1938, rendered March 19, 1939, called attention to the fact that 1938 was one of recession generally in all lines of business, but that the company's gross revenues actually exceeded those of the year before, a high record year. The report explained that the company's showing was "due primarily to the uninterrupted growth in domestic and commercial sales," and added:

The aggressive new business campaign which the Company has carried on during the past several years, was continued in 1938 and enabled us to add a substantial number of new customers to our lines and to build up the uses of existing customers in the household and commercial classifications.

Elsewhere in the same report, the stockholders were told that the company's largest gain in revenues was the result of increased business from domestic customers, and were reminded of "our continued intensive load-building campaign in the home * * *." So too, the 1939 report, rendered March 15, 1940, no less than the reports for the prior years, indicated nothing other than a sustained and persistent effort to increase petitioner's load.

Notwithstanding petitioner's present attempts to explain these reports away, they speak too loudly and persuasively to be ignored. Nothing in those reports suggests that petitioner was merely following a "selective" or a "controlled" load building program, whereby it deliberately sought to dispose of certain blocks of power to another utility (Pacific Gas and Electric) at a low profit rather than to increase the more profitable household consumption. The inference is altogether too plain that, within the limits of good business judgment as petitioner understood them, it was doing everything it reasonably could do to increase the sales of its power and to increase it earnings.

The conclusion that we have just reached with respect to the evidence which bore most directly upon this factual issue makes it unnecessary to discuss in detail the great mass of evidence tendered by petitioner that was calculated to establish by inference that it restrained its sales efforts. Petitioner undertook to show in this connection that, without the coming of Boulder power, it was actually faced with a "power shortage" during the last half of 1939, that such shortage was anticipated by the end of 1936, and that, accordingly, it would not have been consistent with prudent management to embark on an "all out" sales program. We have attempted in our findings to set forth fully the facts relating to this matter. One of petitioner's principal witnesses in his connection was its executive vice president, Harold Quinton, who had not been an officer of petitioner during the base period, and could do little more than guess as to petitioner's actual sales practices during those years. He stated candidly that "I am unable to testify * * * of my own knowledge, there was any curtailment of sales program in the base period years."

Concerning petitioner's supply of power, the evidence shows that petitioner had a total productive capacity, on its own generating units, of about 930,000 kilowatts of "rated" or "installed" capacity; out of this capacity, petitioner early in 1937 made available to the City of Los Angeles on a rental basis a steam generating unit of 60,000 kilowatts, thereafter leaving petitioner a rated capacity of about 870,000 kilowatts. However, that rated capacity of 870,000 kilowatts represented, in part, 499,000 kilowatts attributable to its hydro system, and therefore in dry years or in those portions of any particular year when rainfall was low, petitioner could not count upon that amount of power in full. Petitioner's hydro power consisted in turn of a total of 92,000 kilowatts from so-called stream-flow plants and 397,000 kilowatts from reservoir-supported plants. In the case of the stream-flow plants the power had to be taken advantage of at once as the water moved downstream or it would be forever lost. In the case of its reservoir-supported plants, petitioner could, within limits, impound the water and use it as it was needed. In June 1939, petitioner increased its productive capacity when it began to receive power from an 82,500-kilowatt generator at Boulder, and in September 1939 it began to receive power from its second 82,500-kilowatt generator at Boulder.

Through this supply, petitioner had satisfied a demand up to October 1936 which included wholesale purchases by the cities of Los Angeles, Burbank, and Glendale. In 1936, petitioner sold a total of about 567 million kilowatt-hours to those 3 cities. During the same year petitioner's total sales to other purchasers were about 2,800 million kilowatt-hours, so that the sales to the cities represented about 20 per cent of its total sales in kilowatt-hours. That substantial portion of petitioner's productive capacity was freed in large part when Los Angeles in late 1936, and the other 2 cities in early 1937, discontinued most of their purchases from petitioner. Since at about the same time Los Angeles began to rent petitioner's steam plant as previously noted, representing about 7 per cent of petitioner's total productive capacity, most of the remaining 13 per cent released by the 3 cities became available for future sale. Other data likewise reflect this decline in demand for petitioner's power. The peak demand -- or highest instantaneous demand -- for petitioner's power in 1936 was 645,400 kilowatts; but in 1937 it declined to 580,500 kilowatts, and to 579,000 kilowatts in 1938. Similarly, petitioner's sales declined from the above-stated quantity of 2,800 million kilowatt-hours to about 2,475 million kilowatt-hours in 1937 and 2,391 million kilowatt-hours in 1938.

Petitioner's peak demand in 1939 occurred at 6:33 p. m. on September 22, and was in the amount of 684,500 kilowatts. If the power from petitioner's generators at Boulder, which were then in fact in operation, be excluded from consideration, petitioner would have had only 796,500 kilowatts available to it at the moment of that peak, thus leaving a reserve of 112,000 kilowatts at that time. Petitioner contends that a prudent "spinning" reserve (described in the findings hereinabove at pp. 945 and 946) for its system called for 100,000 kilowatts available for instantaneous utilization, and that therefore it was virtually without any extra available power at that moment, leaving Boulder power out of consideration.

A sharp controversy has developed between the parties as to whether there was thus in fact a power shortage. We think this is a false issue in this case and do not intend to resolve it, for we do not understand why Boulder power, which in fact became available to petitioner by the last half of 1939, must be excluded from its productive resources at that time.

Since 1930 when petitioner contracted for the purchase of Boulder power, it knew that such power would become available to it, and it fashioned its long range plans in reliance upon such power. Moreover, although it was not required to begin taking Boulder power prior to June 1, 1940, it was not precluded from doing so prior thereto; indeed the City of Los Angeles began to receive its share of Boulder power in 1936, some 8 months prior to its mandatory date. By placing its orders for its generators at Boulder petitioner could control and accelerate the time within which it would begin to receive power from Boulder. And the record before us plainly shows that when studies made by petitioner's engineers towards the end of 1936 indicated the wisdom of obtaining such power during the last half of 1939, petitioner promptly took steps to initiate the construction of its first 2 generators at Boulder. Furthermore, it completed its transmission line to Boulder in 1938, and actually was in position to take advantage of the first generator the moment it was completed in June 1939. True, there were possibilities of delay in construction, but we are satisfied on this record that petitioner was counting upon the availability of power from that generator at about the time that it was in fact ready for operation.

Accordingly, we cannot believe that in shaping its sales policies in 1937, 1938, and the first half of 1939 it was attempting to avoid sales of power that plainly could have been added to its load during that period merely because it feared that such sales might produce a shortage during the last half of 1939. For, with Boulder power, there would be no such shortage, and we are satisfied that petitioner took the availability of such power into account in the formulation of its plans. Whether such power might be charged for bookkeeping purposes to the Metropolitan Water District in order to enable petitioner to obtain it at more favorable rates is a matter of no consequence in this connection. The point is that petitioner had taken effective steps as early as the beginning of 1937 to have its transmission line and its generators constructed, and that in one way or another, it was expecting to obtain Boulder power from its own facilities by the middle of 1939. ¹²

After a full consideration of all the facts developed in this record, both by the direct evidence and the indirect evidence, we are convinced that petitioner did not in fact curtail sales efforts because of any anticipated shortage of power.

3. Although, as we have concluded above, petitioner did not in fact curtail its sales efforts or any sales programs because of any fear of lack of productive capacity or potential productive capacity, there was one occasion when it might have been able to make an unusually large sale of power to the City of Los Angeles beginning in December 1938 if it had then had the additional capacity represented by its Boulder commitment.

At the time Los Angeles began to receive Boulder power in 1936 and therefore largely ceased buying wholesale power from petitioner, it leased a 60,000-kilowatt steam plant from petitioner pursuant to a contract with it executed in 1932. In November 1937 the City notified petitioner by letter that it would need an additional 100,000 kilowatts of capacity by December 1938. It indicated that it contemplated acquiring such additional capacity through the construction of another transmission line to Boulder or through the construction of a steam plant. The latter course apparently would have been in violation of the 1932 contract if petitioner had been prepared to furnish the desired power to the City. The City declared in the letter that it was its "understanding that your company would not be in a position to furnish" this additional capacity, and asked petitioner for an assurance that the construction of a steam plant would not violate the terms of the 1932 contract. Petitioner replied that, provided the City continued to lease the 60,000-kilowatt steam plant, no conflict with the 1932 agreement would result if the City built either the Boulder transmission line or a steam plant.

The implications of this incident are not entirely clear. Yet, we are satisfied, on the whole, that if petitioner had then been in a position to undertake to sell a block of power of this magnitude it would have done so. A correction under (b) (4) is appropriate for this factor. However, in making the correction, we will have to take into account the fact that the sale of such power would probably have been at wholesale rates, and consequently less profitable than other sales made by petitioner. ¹³

4. Apart from the relief that petitioner seeks under (b) (4) by reason of its alleged deliberate failure to take advantage of sales opportunities that actually existed in the base period, it relies also upon potential demand that did not in fact exist during the base period but which, it contends, should be treated as being in existence at that time under a proper application of the push-back rule. The argument made is that petitioner's increased capacity was derived from construction of Boulder Dam; that Boulder Dam brought additional water and power to southern California; that additional water and power meant expansion of economic activity and demand for electricity in that area; and that a push-back of petitioner's increased productive capacity requires a push-back as well of Boulder Dam and its additional water and power, together with the asserted higher level of economic activity and increased demand for electric energy.

Ordinarily, in the application of the push-back rule, it is only the (b) (4) qualifying change that is pushed back. Thus, the statute contemplates merely that the increased productive facilities are to be considered as having been available 2 years earlier, and the relevant inquiry is whether such new facilities would have resulted in more earnings under the economic and other conditions as they in fact existed during the base period. Cf. National Grinding Wheel Co., 8 T. C. 1278; Green Spring Dairy, Inc., 18 T.C. 217">18 T. C. 217, 240.

However, the foregoing is not an inflexible rule, and there may be exceptional situations that justify taking into account certain assumed conditions during the base period as well as the (b) (4) qualifying change itself. This has been recognized by the regulations (section 35.722-3(d), Regulations 112), and an example given in the Bulletin on Section 722 makes clear the necessity for such exceptional treatment (p. 75):

Certain operating conditions which did not and could not exist throughout the base period may be assumed to exist during such period if these conditions were the basis of the taxpayer's change or commencement of business and if they constitute normal and essential operating conditions. Thus, for example, suppose a dam was built in January 1939 making a river navigable. Immediately thereafter a corporation was formed to furnish a ferry service across the river. Service began in June of 1939 and continued thereafter. The navigability of the river, made possible by the dam, must be considered one of the normal operating conditions of the corporation. As such, it must be assumed to have been in existence throughout the entire base period.

Thus, a condition that is inextricably associated with the qualifying (b) (4) change may, in proper circumstances, be treated as accompanying that change in the application of the push-back rule. Whether the construction of Boulder Dam and all that it implies is such a condition is the question here. We think that it is.

The very appropriation of funds for the building of the dam was conditioned upon the Secretary of Interior's obtaining assurances that the project would be self-liquidating over a period of 50 years. Petitioner was one of the principal allottees of power to be generated, and by its commitment to take such power in its 1930 contract it became in substance one of the underwriters of the project. We agree that the commitment should not be considered in isolation, and that by virtue of its unusual relation to the project both must be considered together.

However, our difficulty at this point is that the record before us does not furnish us with any satisfactory guides to determine how much additional demand, if any, there would have been for power during the base period if the project as a whole were pushed back 2 years. The evidence contains many general statements, primarily of a hearsay character, made by persons not available for cross-examination, about the expected role of Boulder Dam in the future development of southern California. Certainly, those statements viewed with optimism and ardor the effect that the project would have with time. But none of them was related to the question before us, namely, what effect it would have had during the base period if it had been transposed backwards in time pursuant to (b) (4). It may well be that other economic factors during the base period overshadowed the potential benefits from the project at that time. The evidence fails to show that economic conditions during the base period otherwise were such that additional power and water supplies would have sufficed to induce the considerable rise in activity and demand for electricity contended for by petitioner. The record is just as consistent with the conclusion that there were limiting factors in operation during the base period which might have circumscribed the effect of additional supplies of power and water, and that availability of these supplies would not have materially improved economic conditions and the demand for electric power during the base period in the area served by petitioner.

Whether a substantial increase in migration of population and industry to southern California during the base period would have occurred by reason of a 2-year earlier start on the Boulder project is highly conjectural on the facts before us. We do think, however, that, given two more years, the project might have made itself felt in some degree. We are unable to see how we can do any more than treat it as a "plus" value in the context of this case, and we will therefore give some, but not substantial, weight to this factor in making our final determination.

III

Depreciation and Interest -- Section 722 (b) (5).

Petitioner contends further that its actual base period net income must be corrected for two additional factors which it asserts abnormally reduced its net earnings during the base period. The first of these consists of excessive depreciation deductions; these were taken at rates which respondent subsequently found to be too high, but as to which he was restricted by the statute of limitations in making a retroactive correction, so that correction was made for 1939 by reducing the depreciation for that year but no correction was made for the prior 3 years of the base period, leaving the depreciation for those years in their original excessive amounts. The other deals with deductions for interest on long-term indebtedness which at least in part was retired or refunded before the end of the base period, thereby eliminating the related interest charges and reducing total interest expense.

These circumstances are asserted by petitioner to constitute qualifying factors within section 722 (b) (5), under which relief is available if it be shown that the average base period net income is an inadequate standard of normal earnings because "of any other factor affecting the taxpayer's business" which meets stated requirements. Petitioner argues, moreover, that adjustment must be made for the abnormalities in base period net income introduced by these factors even if they do not themselves qualify under the statute.

In this last contention we think petitioner is correct, and we therefore need not determine whether (b) (5) is here satisfied. Since we otherwise find petitioner to be entitled to relief under section 722, it becomes necessary to reconstruct an average base period net income for petitioner as a standard of its normal base period earnings, and respondent has ruled that on reconstruction all abnormalities are to be corrected which stand in the way of arriving at such normal earnings, without regard to whether they are abnormalities which would provide an independent basis for relief under the statute. Thus, in treating the subject of normal earnings, respondent has declared in E. P. C. 6, 1946 -- 2 C. B. 123, at 125-126:

In using base period experience in the determination of normal earnings, it is necessary to take account of abnormalities; i. e., substantial and outstanding departures from the usual and ordinary income and expense that would be expected to characterize the profits history of the taxpayer during such a period. Thus appropriate adjustment will be made for all such abnormalities, whether favorable or unfavorable to the taxpayer and whether or not attributable to the qualifying factor. Such adjustment will usually take the form of eliminating, reducing, or increasing items of gross income or deduction. * * *

On later consideration of E. P. C. 6, respondent reaffirmed in E. P. C. 13, 1947 -- 1 C. B. 83, at 86, that "Such abnormalities are corrected whether or not they constitute qualifying factors and regardless of whether the consequences are favorable or unfavorable to the taxpayer." The quoted portion of E. P. C. 6 has been approved by this Court, which has said that it is "sound and in harmony with the statute," cf. East Texas Theatres, Inc., 19 T. C. 615, 626, and it must be given effect here to the extent that it is applicable. We think that the circumstances as to the depreciation and interest give rise to abnormalities within E. P. C. 6, and that correction must be made for them.

1. The facts as to the depreciation deductions are that, during the four base period years, petitioner took such deductions according to depreciation rates which respondent approved. In June 1943, following consultation between petitioner and respondent, the depreciation rates applicable to many of petitioner's assets were reduced. The reduced rates were then applied both prospectively to later years, including the taxable years in issue, and retroactively to earlier years, but, because of the statute of limitations, they were given no effect prior to 1939. In other words, petitioner's depreciation for 1939 was reduced in accordance with the new lower rates, but its depreciation for the years 1936 through 1938 was left unchanged, in accordance with the old higher rates. If the rates applied to 1939 were also used for the earlier base period years, petitioner's depreciation would be reduced and its net income would be increased by $ 1,652,184.95 for 1936, $ 1,666,674.58 for 1937, and $ 1,685,035.25 for 1938.

Respondent does not contend that the new lower rates were in any way improper, or that they were any less appropriate to measure depreciation for 1936 through 1938 than for 1939. Accepting these rates and giving them application for 1939, we are unable to see why a distinction should be drawn between that year and the earlier years, and how normal earnings under section 722 can be determined without also giving those rates effect for the earlier years. Having recognized them as proper for determining normal earnings for 1939, there is no valid reason, so far as a reconstruction under section 722 is concerned, for not acting consistently and using the same rates to determine normal earnings for the earlier 3 years as well. We therefore hold that E. P. C. 6 requires that correction be made here for excessive depreciation.

2. Petitioner's claim regarding the interest deductions grows out of a reduction in certain interest costs payable on long-term indebtedness which was part of its capital structure during the base period. That claim is divisible into 3 parts.

First, between the beginning and the end of the base period petitioner retired, and so reduced, its long-term indebtedness by $ 31,577,000. This retirement was made in three different security issues, and during each of the four base period years. At the same time, of course, petitioner reduced the amount of interest payable. Petitioner contends that by the end of the base period its normal earnings consisted of income unreduced by the interest costs thus eliminated; that by the end of that period there had been a reduction in its interest charges and a corresponding increase in its net earnings which must be taken into account in ascertaining its normal base period earnings as a standard for comparison with earnings during the taxable years in issue; that, unless the reduction in interest costs is reflected in that standard of comparison, earnings attributable solely to these base period interest savings will be improperly taxed as war profits during the years in issue.

Keeping in mind E. P. C. 6, we think petitioner's average base period net income is abnormally low for failure completely to reflect these reduced interest charges, and that this is an abnormality which requires correction. Indeed, in considerable part it resembles in nature one situation dealt with in section 722 (b) (4), which makes eligible for relief a taxpayer which changes the character of its business by effecting "a difference in the ratio of non-borrowed capital to total capital." The amount of correction suggested by petitioner, however, is too great in that it fails to take into account the fact that the indebtedness and its related interest were being reduced throughout the four base period years, and that therefore there were years in the base period when portions of the indebtedness had already been retired and in which petitioner's actual earnings reflected the resulting reduction in interest. Correction is needed only to the extent that the actual earnings do not reflect the interest savings.

Secondly, in September 1939 petitioner refunded a bond issue in the face amount of $ 30,000,000, maturing in 1960 and carrying an effective interest charge of about 4 per cent. This issue was replaced by one maturing in 1964, and carrying a lower effective interest charge, with the result that an annual interest expense of about $ 1,205,074 was reduced to about $ 927,382, working a saving of about $ 277,692 in interest per year.

To the extent that petitioner's average base period net income fails to reflect this reduction in interest, we think it likewise contains an abnormality which requires correction under E. P. C. 6 for essentially the same reasons as obtain respecting the retired indebtedness. Respondent argues that the general trend of utility interest rates was in a downward direction during the base period, and that petitioner's experience in reducing its interest charges spelled normality rather than abnormality. It is nonetheless true that by the end of the base period petitioner had achieved an interest structure which was normal and which was not sufficiently reflected in its actual earnings experience in prior years, making necessary a correction in that experience. Respondent further says that account need be taken of this interest reduction only in so far as there was an actual saving in 1939, which, because the refunding came in September, operated only during the last 4 months of the year and amounted only to about $ 92,500 for that year; petitioner argues that the saving should be put on an annual basis, and adjustment should be made according to the amount of saving that could be realized over a full year, $ 277,692. We believe we must agree with petitioner, if the abnormality is to be completely eliminated. However, even so petitioner is not entitled to a correction of $ 277,692 in its average base period net income, but to something less, because to some extent that saving is already reflected in its base period net income, since the lower interest charge was operative during the last third of 1939. Only for the remainder of the saving should correction be made.

Thirdly, in January 1941 petitioner refunded another of its bond issues. At the end of the base period petitioner had outstanding bonds in the face amount of $ 108,000,000, which mature in 1960 and on which the effective interest rate was about 4 per cent. In October 1940 a new issue of petitioner's bonds was sold in the same face amount, but maturing in 1965 and carrying a lower effective interest rate, and on January 1, 1941, the proceeds from the new bonds were used to retire the old ones. Petitioner contends that the resulting interest saving entitles it to some adjustment in its base period income. We cannot agree.

Effect cannot be given to this transaction in reconstructing petitioner's income without relying on events which transpired after 1939, if only to look to whether the refunding took place. To refer to post-1939 events for this purpose, however, is to contravene the prohibition in section 722 (a) that "In determining such constructive average base period net income no regard shall be had to events or conditions * * * occurring or existing after December 31, 1939 * * *." Cf. Alexandria Amusement Corporation, 16 T. C. 446, 455-456;Clinton Carpet Co., 14 T. C. 581, 585-588. And the exception for commitment cases certainly cannot be effective in connection with alleged abnormalities having nothing whatever to do with the commitment. Petitioner apparently attempts to meet this objection by seeking an adjustment, not amounting to the difference in interest cost achieved in reducing the old interest rate to the new rate actually in effect on the new issue, but in a lesser amount determined by the difference between the old interest rate and the effective rate at which it says the refunding might have been accomplished at the end of 1939. Petitioner asserts that the only reason this refunding was not completed in 1939 rather than in 1941 is that it had to pay a premium on retirement of the old issue, and the premium was considerably higher in 1939 than in 1941. We are not entirely convinced, however, that petitioner could have refunded the $ 108,000,000 issue in 1939 at the reduced interest rate for which it contends. It must be remembered that petitioner had already refunded its $ 30,000,000 issue in 1939, and whether the condition of the market in 1939 was such as to have permitted the absorption of such a large additional refunding issue by the same corporation at that time is a matter on which the record contains no satisfactory evidence. Moreover, even if petitioner could have successfully achieved such a refunding in 1939, the fact is that it did not do so, and we know of no basis upon which we can approve petitioner's position in this respect. If petitioner had found it advantageous to wait until 1942 or 1943 or 1945, would it be necessary to make some adjustment merely because it might have chosen to act in 1939? We do not read the statute to permit such a result.

We come, finally, to the question of the amount of relief to which petitioner is entitled under section 722. Petitioner computed its excess profits credit according to the earnings method. But while a straight average of its base period earnings for the 4 years amounted to about $ 11,700,000, the credit actually used by petitioner was much higher, amounting to about $ 14,300,000. This increase of about $ 2,500,000 in petitioner's credit resulted from an application of the "growth formula" of section 713 (f), which reflects increased income experienced by a taxpayer showing a trend of increasing earnings toward the end of its base period. The growth formula accomplishes this result through placing predominant emphasis, in its calculation, on the taxpayer's last two base period years, and, because many of the abnormalities observed by us to have existed in petitioner's base period experience were in good part ameliorated by or during those last 2 years, petitioner has already received a substantial measure of relief through application of the growth formula. Thus, depreciation for 1939 has been reduced through use of the new lower rates, and as to the resulting deduction for that year there is now no complaint. By 1938 and 1939, a large portion of the base period retirement of indebtedness had already taken place, and the reduced interest charge flowing from the first of the two refundings discussed above was operative during part of 1939. Repair of the damage done by the loss of the cities' business was fully achieved no later than about the middle of 1939, so that during 1938 and 1939 petitioner experienced increasing and finally complete correction for that loss. Abnormalities in petitioner's base period earnings therefore have already been partially corrected through the growth formula. We also recognize that it has been held that where a taxpayer's credit is increased through the growth formula, it must show, in order to be entitled to relief under section 722, that a proper reconstruction under section 722 of its average base period net income would produce a credit greater than the credit resulting from the growth formula. Irwin B. Schwabe Co., 12 T. C. 606, 613-614; Studio Theatre Inc., 18 T.C. 548">18 T. C. 548, 566. Cf. Stimson Mill Co., 7 T. C. 1065, affirmed, 163 F. 2d 269 (C. A. 9), certiorari denied, 332 U.S. 824">332 U.S. 824; Homer Laughlin China Co., 7 T. C. 1325; Dowd-Feder, Inc., 10 T.C. 345">10 T. C. 345, affirmed, 173 F. 2d 673 (C. A. 6). However, there has been only partial correction for the abnormalities we have found to be present, and we are satisfied that their complete correction requires adjustment of petitioner's average base period net income to a level in excess of its credit under the growth formula. Keeping in mind the benefits already derived by petitioner through the growth formula, taking into account all the considerations we have discussed, and giving effect to all the relevant facts and circumstances established by the record, we have concluded that petitioner is entitled to a constructive average base period net income of $ 1,200,000 in excess of its average base period net income computed without regard to section 722.

Decisions will be entered under Rule 50.

---

Footnotes

• 1. One small plant and a small generating unit were abandoned during the base period because of obsolescence and flood damage.↩

• 1. Inasmuch as the figures have been rounded to the closest million, they do not always add up to the totals shown.↩

• 1. The monthly figures have been rounded to the closest million, so that they do not always add up to the totals shown.↩

• 1. These are quantities before reduction for power loss in transmission and distribution, which ranged from 18.01 per cent to 21.54 per cent in the base period.↩

• 1. The figures are rounded to the closest million, so that they do not always add up to the totals shown.↩

• 2. Such a situation existed in 1924, when petitioner had kilowatt capacity of 355,300 available at the time of a peak demand of 330,710, but due to a shortage of water the delivery of kilowatt-hours during the year was insufficient.↩

• 1. The figures are rounded to the nearest million, so that they do not necessarily add up to the totals shown.↩

• 1. The quantities shown are before reduction for power loss in transmission and distribution, which ranged from 18.01 per cent to 21.54 per cent in the base period.↩

• 3. In preliminary investigation, the possibilities of constructing a dam on the river at either Boulder Canyon or Black Canyon were explored; the latter, however, was finally selected as the site for the project, but the dam constructed at that point became known as "Boulder Dam." At the beginning there was also some reference to it as Hoover Dam (e. g., 46 Stat. 1115, 1146), and in 1947 that name was given to it. 61 Stat. 56. In the interim and at the time of events here involved, however, it was known as Boulder Dam and has been thus referred to by the parties and by documents introduced in evidence herein; for convenience, it is so referred to by us.↩

• 4. An additional 90,000,000 kilowatt-hours per year of firm energy, resulting from an increase in the height of the Dam also was contracted for by the City of Los Angeles.

  The obligation of the City, for 37 per cent, was reduced shortly thereafter because the cities of Pasadena, Glendale, and Burbank entered into supplemental contracts for "firm energy." Similarly, petitioner's obligation for 27 per cent was reduced because Los Angeles Gas & Electric Co. and Southern Sierras Power Co. entered into supplemental contracts for "firm energy."

  The foregoing allotments were subject to being reduced still further to the extent that the states of Arizona and Nevada exercised rights accorded to them to take Boulder power. The precise amounts and percentages, relating both to firm and secondary power, are set forth in a stipulation of the parties which we have incorporated herein by reference.↩

• 1. For the years 1937 to 1945, inclusive, there is included the sum of $ 575,000 received as payment for the rental of a standby plant to the City of Los Angeles Department of Water and Power.↩

• 1. The figures starting at this point assume that one transmission line and two generators will be available on petitioner's system.↩

• 1. Secondary power under interim contract of 1938.↩

• 2. Includes 115,313,700 KWH secondary power under interim contract of 1938.↩

• 5. After the ranges had been leased for 5 years, petitioner's investment therein had already been recouped and it allowed the lessees to use the range without further rent.↩

• 1. This figure is before declared value excess profits tax of $ 138,681.77.↩

• 2. In this year, there was a deduction for unamortized bond discount and expense and call premium.↩

• 1. "National" net income has been adjusted by adding back depreciation, interest, amortization, and Federal income taxes; and interest and depreciation have been added back to petitioner's income.↩

• 1. Computation of excess profits net income varies, depending on the taxable year for which the computation is made.↩

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

  (a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, except that in the cases described in the last sentence of section 722 (b) (4) and in section 722 (c), regard shall be had to the change in the character of the business under section 722 (b) (4) or the nature of the taxpayer and the character of its business under section 722 (c) to the extent necessary to establish the normal earnings to be used as the 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 --

  (1) in one or more taxable years in the base period normal production, output, or operation was interrupted or diminished because of the occurrence, either immediately prior to, or during the base period, of events unusual and peculiar in the experience of such taxpayer.

  (2) the business of the taxpayer was depressed in the base period because of temporary economic circumstances unusual in the case of such taxpayer or because of the fact that an industry of which such taxpayer was a member was depressed by reason of temporary economic events unusual in the case of such industry,

  * * * *

  (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, * * * Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, or

  (5) of any other factor affecting the taxpayer's business which may reasonably be considered as resulting in an inadequate standard of normal earnings during the base period and the application of this section to the taxpayer would not be inconsistent with the principles underlying the provisions of this subsection, and with the conditions and limitations enumerated therein.↩

• 7. During the year 1936 petitioner sold a total of 567,151,000 kilowatt-hours to the three cities and received revenues aggregating $ 3,381,122 from them. In the years 1937, 1938, and 1939, such sales accounted for only 53,689,000 kilowatt-hours, 13,299,000 kilowatt-hours, and 44,100,000 kilowatt-hours, respectively, and petitioner received as revenues (including the $ 575,000 rentals) from the cities $ 991,164, $ 604,555, and $ 893,956 in the respective years.↩

• 8. It should be noted that the regulations cited above state that the events "contemplated in section 722 (b) (1) consist primarily of physical rather than economic events or circumstances." (Italics supplied.) The regulations do not limit the provision exclusively to physical events or circumstances. Cf. Alison v. United States, 344 U.S. 167">344 U.S. 167↩.

• 9. Cf. Treasury Department Bulletin on section 722 (1944), at p. 11:

  Physical events such as are contemplated in section 722 (b) (1) may give rise to economic effects which in turn cause an interruption or diminution of operations. In such cases it may be difficult to determine whether section 722 (b) (1) or section 722 (b) (2)↩ is applicable. Ordinarily, it will not be necessary to make the distinction, since the taxpayer is entitled to relief in either case, provided the resulting inadequacy of average base period net income is established.

• 10. See Regulations 112, sections 35.722-3 (a), 35.722-3 (b); Bulletin on Section 722↩, pp. 12, 18-19.

• 11. The general prohibition against resort to post-1939 events was introduced in the House in the bill which became the Revenue Act of 1942 (H. R. 7378, 77th Cong., 2d Sess., sec. 213). The report of the House Ways and Means Committee stated (H. Rept. No. 2333, 77th Cong., 2d Sess., p. 142):

  In order to eliminate consideration of the effects of the war, it is provided that, in determining the constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, an industry of which it is a member, or taxpayers generally, occurring or existing after December 31, 1939. Thus high war prices, swollen demand, and other factors which would not be normal prior to the imposition of the excess profits tax shall be eliminated in the computation of the normal or average earning capacity of the taxpayer.

  The exception for commitment cases was added by the Senate. The Senate Finance Committee's report, in commenting on this provision, first reads as quoted above, and then merely adds (S. Rept. No. 1631, 77th Cong., 2d Sess., p. 198):

  Your committee has provided, however, that in those cases described in the last sentence of section 722 (b) (4), relating to taxpayers the change in the character of the business of which accrued after December 31, 1939, * * * regard shall be had to the change in the character of the business under section 722 (b) (4)↩ * * * to the extent necessary to establish the normal earnings to be used as the constructive average base period net income.

• 12. Moreover, if delays were to be encountered in connection with the completion of its own facilities, the record shows that other sources of power could have been made available to petitioner on an emergency basis, particularly surplus power of the Metropolitan Water District. It is clear that petitioner knew there would be such surplus power at that time and had even considered the means for bringing it into its own distribution system. While we do not suggest that petitioner would have sold power merely upon the expectation of receiving it from such emergency sources, the fact that such sources did exist made it more prudent for petitioner to rely upon obtaining power from its own Boulder facilities by the middle of 1939.↩

• 13. Petitioner also seems to suggest, although it is not clear that it insists, that its base period earnings ought to be increased to reflect anticipated additional wholesale sales to the Pacific Gas and Electric system, a utility which operated in California but outside the southern part of the state. By the end of 1939, petitioner had agreed to supply 75,000 kilowatts a year to P G and E. Thereafter, in April 1940 petitioner contracted to supply P G and E additional power, up to a total of 150,000 kilowatts or 815,000,000 kilowatt-hours per year for 1942 through 1945. Petitioner seems to indicate that correction should be made in base period earnings for the increase in sales provided for in the 1940 contract.

  In this, we consider petitioner to be clearly wrong, because it seeks improperly to go beyond the base period in ascertaining normal earnings. The situation here is not like that of the City of Los Angeles discussed above; there is no showing at all that P G and E wanted more power delivered during the base period and that, if petitioner had more productive capacity in the base years, it could have increased its sales to P G and E during those years. Petitioner's position is based rather on the contract executed in 1940, and appears to contend for a correction determined according to the terms of that contract. That is prohibited by the statutory injunction against consideration of post-1939 events; while some account may be taken in commitment cases, as we have noted, of events after 1939, the scope of permitted reference is not so broad as to allow what petitioner argues for here. Nor would petitioner be in any better position if it were to rely on its "projective type mechanism" here. The objections on principle to such an approach have already been discussed, supra↩, pp. 52, 53, 55. Here, moreover, there is an insufficient factual foundation for applying that approach, in that the evidence fails to establish whether there was a reasonable expectation as of the end of 1939 that there would be an increase, or the extent thereof, in sales to P G and E. We are not satisfied on the evidence before us that petitioner and P G and E had come to any understanding before the end of 1939 for the sale of any additional power or that negotiations between them had progressed to such a point that the consummation of an agreement for the sale of additional power could reasonably be anticipated at that time; moreover, the agreement ultimately reached thereafter was conditional and dependent on approval by the state utilities commission, which might have withheld approval completely or granted it on terms varying from those agreed upon by the parties.