Pratt & Letchworth Co. v. Commissioner

Pratt & Letchworth Company, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Pratt & Letchworth Co. v. Commissioner Docket No. 29502 United States Tax Court 21 T.C. 999; 1954 U.S. Tax Ct. LEXIS 260; March 25, 1954, Promulgated *260 Decision will be entered for the respondent. 1. Excess Profits Tax Relief Under Sec. 722 (b) (2), I. R. C. -- Held, a contract under which most of petitioner's production was reserved for one customer did not bring about a restriction in petitioner's sales promotional activities which was either temporary or unusual; the contract was the result of an internal management decision and could not form the basis for relief; and petitioner's earnings were not depressed during the base period. 2. Subsec. (b) (4). -- Held, within the meaning of subsection (b) (4) the elimination of petitioner's malleable iron production was not a change in the character of the business and the alleged change did not take place during or immediately prior to the base period nor did it result in an inadequate standard of normal earnings during any portion of the base period. 3. Subsec. (b) (5). -- Held, as no new grounds for relief were stated, petitioner failed to establish its eligibility for relief. Sol Goodman, Esq., for the petitioner. John Clark, Esq., for the respondent. Bruce, Judge. BRUCE *1000 This proceeding involves petitioner's claim for refund of excess profits tax under section 722 of the Internal Revenue Code for the fiscal years January 1, 1940, to August 31, 1940; September 1, 1940, to August 31, 1941; and September 1, 1941, to August 31, 1942, in the amounts of $ 26,826.55, $ 55,994.05, and $ 68,621, respectively. Respondent disallowed, in full, petitioner's claim for each of the fiscal years involved on the ground that petitioner had not established its right to relief under any of the provisions of section 722. FINDINGS OF FACT. Petitioner is a corporation organized under the laws of the State of New York with its principal offices in Buffalo, New York. The returns for the periods here involved were filed with the collector of internal revenue for the twenty-eighth district of New York. During the period 1920 through 1939, inclusive, petitioner and its predecessors*262 were engaged primarily in the making of malleable iron and steel castings, coils springs for railroads and railway supplies, housings, and forgings. These activities were carried on in petitioner's plant at Buffalo, New York. Prior to 1920 the business was carried on by Pratt & Letchworth Company, a New York corporation. On December 31, 1923, all of the assets and capital stock of said company were purchased by Dayton Malleable Iron Company. Pratt & Letchworth Company continued to carry on the business leasing the plant and equipment from Dayton Malleable Iron Company at a stipulated rental. On July 1, 1926, Pratt & Letchworth Company, the New York corporation, was dissolved and a corporation bearing the same name, but organized under the laws of Ohio, was substituted as the operating company. On January 1, 1932, the present petitioner, Pratt & Letchworth Company, Inc., was organized under the laws of New York and acquired all the assets of the Ohio corporation. At the same time petitioner acquired from Dayton Malleable Iron Company, which owned all of petitioner's capital stock, the plant and equipment which previously had been leased to the operating companies. Dayton Malleable*263 Iron Company had received up to that time $ 1,298,333.26 in rentals from the operating companies. Hereinafter the present petitioner and its predecessors will be referred to collectively as the petitioner. Throughout the years 1920 to 1939, inclusive, petitioner operated as virtually a one customer house, W. H. Miner, Inc., being the principal customer. All products made for W. H. Miner, Inc., as well as products made for a number of petitioner's other customers, were for use in *1001 the railroad industry. More than half of petitioner's production in each of the years from 1920 through 1939 went to the railroad industry. Prior to 1927 petitioner produced both malleable iron and steel castings. In 1927, W. H. Miner, Inc., started to discontinue the use of malleable iron in products manufactured for it by the petitioner and began using cast steel. This conversion from malleable iron to cast steel by W. H. Miner, Inc., was completed by 1929. This business was not lost to petitioner, however, for it continued to make the same products for W. H. Miner, Inc., out of cast steel instead of malleable iron. But this conversion by W. H. Miner, Inc., eliminated over 60 per cent of*264 petitioner's malleable iron business, and it became no longer profitable for petitioner to continue operating its malleable iron foundry. Petitioner cut down thereafter on its production of malleable iron products and in 1935 entirely eliminated malleable iron production. Shipments of malleable iron products in 1936, and possibly a large percentage of such shipments in 1934 and 1935, represented accumulated stock produced in prior years. The following table sets forth the malleable iron and steel tonnage shipped by petitioner in the years 1921 to 1939, inclusive: Year Malleable Steel [1921] 9,434 1,894 [1922] 18,829 7,665 [1923] 22,345 12,584 [1924] 19,369 6,417 [1925] 17,474 7,887 [1926] 15,377 8,457 [1927] 8,029 17,495 [1928] 2,107 16,363 [1929] 6,736 22,790 [1930] 4,106 16,179 [1931] 1,840 6,007 [370] 3,019 [41] 3,436 [737] 5,028 [817] 3,168 [12] 8,772 [1937] 15,430 [1938] 3,888 [1939] 5,164 Throughout the base period that portion of petitioner's plant where malleable iron products had previously been manufactured, was, for the most part, abandoned for production and used only for miscellaneous storage. During that period petitioner's*265 existing capacity was sufficient to take care of the demand for its products without converting the malleable iron foundry. Even if the demand had been great enough to warrant production in excess of existing capacity, petitioner did not have sufficient melting capacity to utilize the additional space. Stopping malleable iron production had only one effect on petitioner's earnings during the base period. It eliminated possibility of losses on a branch of petitioner's business which its management deemed unprofitable. In 1930 approximately 75 per cent of the output of petitioner's steel foundry and approximately 100 per cent of the output of petitioner's spring plant was being purchased by W. H. Miner, Inc. At that time petitioner was reserving approximately the above percentages of its production for W. H. Miner, Inc., as a matter of courtesy *1002 to its principal customer. Petitioner had granted W. H. Miner, Inc., a similar preference in the utilization of its productive capacity since 1920. At the suggestion of John C. Haswell, president of both petitioner and the Dayton Malleable Iron Company, a contract was entered into between said corporations and W. H. Miner, Inc., *266 dated December 24, 1930. The contract provides that for a 5-year period beginning January 1, 1931: 1. Petitioner "agrees to reserve seventy-five (75%) per cent of the capacity of its steel foundry and such percentage of the capacity of its spring plant as shall be necessary" for the requirements of W. H. Miner, Inc., and 2. W. H. Miner, Inc., agrees to purchase from petitioner at certain stipulated prices per pound all of its requirements for friction draft gears and springs. The contract was, in general, advantageous to petitioner as a severe depression followed its execution. On December 31, 1935, the contract terminated and was not renewed. While the contract was in effect and prior to that time, petitioner maintained a small sales force as most of its production was either explicitly or tacitly committed to W. H. Miner, Inc. The evidence does not disclose that petitioner's sales force was increased after the termination of the contract. During the base period petitioner sold a greater percentage of its total production to W. H. Miner, Inc., and had fewer customers than it did while the contract was in effect. The percentage of petitioner's production sold to W. H. Miner, *267 Inc., and the average number of petitioner's customers in each of the years 1931 to 1939, inclusive, were as follows: Percentage of total tonnage Average Year produced number of shipped to W. H. customers Miner, Inc. [1931] 60.75 [1932] 73.66 [1933] 84.80 [1934] 80.99 [1935] 51.96 [1936] 81.29 [1937] 90.97 [1938] 89.34 [1939] 68.37 [35] Petitioner is entitled to use an excess profits tax credit based upon income pursuant to section 713 of the Internal Revenue Code. Petitioner's average excess profits net income (before Federal income taxes) from 1922 to 1939, inclusive, was $ 81,149.19. During the base period petitioner's average excess profits net income was $ 168,217.82, or 207.3 per cent of its average net income during the 18-year period, 1922 to 1939. The average base period net income of other corporations engaged primarily in manufacturing railroad *1003 equipment was approximately 75 per cent of their average earnings over the 1922 to 1939 period. Petitioner's excess profits credit, computed under the invested capital method, for each of the taxable periods involved is as follows: From Jan. 1, 1940, to Aug. 31, 1940 $ 170,361.01 Year ended Aug. 31, 1941 168,652.74 Year ended Aug. 31, 1942 165,482.76 *268 For the first two periods, ending on August 31, 1940, and August 31, 1941, respectively, petitioner used the above credits computed under the invested capital method. For the period ending on August 31, 1942, petitioner used an excess profits credit of $ 164,106.04 computed from average base period net income (before taxes) using the deficit formula of section 713 (e) of the Code. OPINION. Petitioner alleges that its excess profits taxes for the taxable periods January 1, 1940, to August 31, 1940; year ended August 31, 1941; and year ended August 31, 1942, are excessive and discriminatory and here seeks relief under the provisions of section 722, Internal Revenue Code. Specifically, petitioner invokes subparagraphs (2), (4), and (5) of section 722 (b). 1 *269 *1004 The petitioner bases its claim for relief under section 722 (b) (2) upon the existence of the contract with W. H. Miner, Inc., during the 5-year period immediately prior to the base period. Petitioner contends that the contract restricted its opportunities to obtain customers in that the majority of its production was committed under the contract to W. H. Miner, Inc. Petitioner further contends that this restriction resulted in a lack of customers and a depression of its business during the base period. It is respondent's position that, even if petitioner's business was depressed during the base period and for the reason stated, the depression was not due to "* * * temporary economic circumstances unusual in the case of such taxpayer * * *" within the purview of the statute invoked. We think respondent's position is well taken. The alleged temporary and unusual economic depression, if one existed, was admittedly self-imposed. The alleged depression was brought on by the managerial decision, internally determined, to enter into the 5-year contract with W. H. Miner, Inc. The contract was, in fact, instigated by petitioner's president. In the Bulletin on Section 722 *270 of the Internal Revenue Code, part III, at page 16, issued by the Commissioner on November 2, 1944, the scope and intendment of section 722 (b) (2) and of the term "economic circumstances" used therein are explained as follows: The term "economic" includes any event or circumstance, general in its impact or externally caused with respect to a particular taxpayer, which has repercussions on the costs, expenses, selling prices, or volume of sales of either an individual taxpayer or an industry. Thus, not every event or circumstance which has an adverse effect on a taxpayer's profits may serve to qualify that taxpayer for relief under subsection (b) (2). First, the temporary and unusual character of the circumstance or event must be clearly established. Second, the cause of the temporary depression must be shown to be external to the taxpayer, in the sense that it was not brought about primarily by a managerial decision. *1005 A taxpayer cannot qualify for relief under subsection (b) (2) because its earnings were temporarily reduced in the base period in consequence of its own business policies, internally determined * * * The foregoing provision, which has often been approved*271 by this Court, Granite Construction Co., 19 T. C. 163, is applicable to the instant case and disposes of petitioner's claim under section 722 (b) (2). There also exist additional reasons for denying the relief sought under subsection (b) (2). Although the contract with W. H. Miner, Inc., was unique in the corporate life of petitioner, the resulting restriction on sales promotion from which the depression allegedly stemmed was neither unusual nor temporary. Petitioner's sales opportunities were similarly restricted even without the contract during the period 1920 to 1931 and throughout the base period by the demands of W. H. Miner, Inc., which purchased the bulk of petitioner's production. Furthermore, petitioner's argument that the termination of the contract with W. H. Miner, Inc., allowed it to obtain more customers is not supported by the evidence. During the base period a much greater percentage of petitioner's total production was sold to W. H. Miner, Inc., and petitioner had far fewer customers than during the period 1931 through 1935 when the contract was in effect. Also, petitioner has not shown that its business was depressed during the*272 base period within the meaning of section 722 (b) (2). Petitioner's average net earnings during the base period were more than double its average net earnings during the 18-year period, 1922 to 1939. See Granite Construction Co., supra, and cases cited therein. The average net profits during the base period of other members of the industry of which petitioner was a member were approximately 75 per cent of their 1922 to 1939 average. These factors tend to show that during the base period petitioner's average net earnings were inflated, not depressed. Petitioner contends that the base period cannot be compared to the 1922 to 1939 period as it paid large rentals to Dayton Malleable Iron Company during the 8-year period, 1924 to 1931. This contention is untenable for, even assuming that petitioner's net earnings over the 18-year period were diminished by the full amount of the rentals paid (which has not been shown) and adding the full amount of the rentals, $ 1,298,333.26, to petitioner's aggregate 18-year net profits, the average base period net income is still greater than the 18-year average, being 109.75 per cent thereof. Petitioner's next contention*273 is that the elimination of its malleable iron production was a change in the character of its business within the purview of section 722 (b) (4). Until 1927 petitioner produced substantial quantities of both malleable iron and cast steel. Between *1006 1927 and 1929 petitioner's principal customer, W. H. Miner, Inc., converted all of its requirements to cast steel. This eliminated 60 per cent of petitioner's malleable iron production. Malleable iron production became no longer profitable for petitioner and was gradually eliminated. The manufacture of malleable iron products was entirely halted prior to 1936. In order to qualify for relief under section 722 (b) (4) petitioner must show that its "* * * average base period net income is an inadequate standard of normal earnings because, within the meaning of subsection (b) (4), petitioner 'either during or immediately prior to the base period, * * * changed the character of the business' and as a result thereof its average base period net income 'does not reflect the normal operation' of the business for the entire base period." Acme Breweries, 14 T. C. 1034, 1054-1055. Under section 722 (b) (4)*274 "* * * the term 'change in the character of the business' includes * * * a difference in the products or services furnished * * *." Such a difference may result from the elimination of a product or service previously furnished. Cf. Bulletin on Section 722, supra, page 50. For example, if the production of malleable iron had resulted in substantial losses and had been eliminated during the base period, it might have been a change within the meaning of subsection (b) (4) as that portion of the base period prior to the change would reflect an inadequate standard of normal earnings. Cf. Bulletin on Section 722, supra, page 127. The elimination of malleable iron production by petitioner, however, was not a change within the meaning of subsection (b) (4). Such a change must be substantial and to be substantial must result in a higher level of normal earnings. Wisconsin Farmer Co., 14 T. C. 1021. Petitioner seems to take the position that the elimination of malleable iron production depressed petitioner's normal earnings. This alone would seem to defeat petitioner's contention that the change was substantial. Cf. Granite Construction Co., supra.*275 Furthermore, even if petitioner had contended that the change resulted in an increased standard of normal earnings, there is no evidence to support such a finding. In addition, the alleged change in the character of petitioner's business did not take place "during or immediately prior to the base period." The change began in 1927 and was 60 per cent complete by the end of 1929. Although the production of malleable iron products was not totally eliminated until 1935, the actual change took place prior to 1930. Cf. Monarch Cap Screw & Manufacturing Co., 5 T. C. 1220, and Acme Breweries, supra. Even if we sustained petitioner's contention that the change resulted from halting malleable iron production in 1935, it still would not have been a change "immediately *1007 prior to the base period" within the purview of subsection (b) (4). Petitioner eliminated malleable iron production because it was unprofitable. In such a case (where no other relevant factors are present) a new normal level of earnings is reached almost immediately with the elimination of unprofitable production. Here production of malleable iron was*276 stopped and presumably a new normal level of earnings was reached prior to 1936. The Bulletin on Section 722, supra, states at page 43: If the normal level of earnings attributable to the * * * change was reached some time prior to the base period, so that the entire actual base period net income reflected the full normal level of earnings, such * * * change will not be considered to have occurred immediately prior to the base period for the purposes of section 722 (b) (4) * * * See also Regs. 112, sec. 35.722-3 (d). We agree with the Commissioner's interpretation of this phrase, and, therefore, the alleged change did not take place "immediately prior to the base period." Also, and for the same reason (i. e., a new normal level of earnings was reached prior to the base period), petitioner has not shown that, as a result of the alleged change, its average base period net income is an inadequate standard of normal earnings and "does not reflect the normal operation" of the business for the entire base period. For the reasons stated above petitioner is not entitled to the relief sought under section 722 (b) (4). There remains for consideration petitioner's contention that it is*277 qualified for relief under section 722 (b) (5). In support thereof petitioner cites no grounds for relief other than a combination of those factors relied upon to support its contentions with respect to sections 722 (b) (2) and (4). Factors relied upon by petitioner to establish eligibility for relief under sections 722 (b) (2) and (4) cannot be considered jointly as a new and different basis for relief under section 722 (b) (5). To do so would violate the statutory prohibition of section 722 (b) (5) that relief granted under that section must "not be inconsistent with the principles underlying the provisions of this subsection, and with the conditions and limitations enumerated therein." Granite Construction Co., supra; Roy Campbell, Wise & Wright, Inc., 15 T. C. 894, 901-902. Therefore, petitioner has not shown that it is qualified for relief under section 722 (b) (5). Petitioner having failed to establish that it qualifies for relief under section 722 (b) (2), (4), or (5), we need not discuss its reconstruction of base period income under those sections. Suffice it to say, however, that petitioner has presented no reconstruction*278 of its base period net income which can be substantiated either in fact or logic. *1008 It has therefore failed in its proof of the requirement that it establish a fair and just amount representing normal earnings to be used as a constructive average base period net income in the computation of its excess profits tax credit. Reviewed by the Special Division. Decision will be entered for the respondent. Footnotes 1. 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 -- * * * * (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, and the acquisition before January 1, 1940, of all or part of the assets of a competitor, with the result that the competition of such competitor was eliminated or diminished. Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, 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.↩