Standard Tube Co. v. Commissioner

The Standard Tube Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Standard Tube Co. v. Commissioner Docket No. 33386 United States Tax Court 26 T.C. 915; 1956 U.S. Tax Ct. LEXIS 110; August 13, 1956, Filed *110 Decision will be entered under Rule 50. Held, petitioner has failed to justify a constructive average base period net income under section 722 (b) (4), I. R. C. 1939, in excess of that allowed it by respondent. Meredith M. Daubin, Esq., for the petitioner. David Kittner, Esq., for the respondent. Bruce, Judge. BRUCE *915 The Commissioner of Internal Revenue allowed petitioner a constructive average base period net income of $ 91,550 under section 722 (b) (4) of the Internal Revenue Code of 1939. Petitioner, to substantiate its claims for refund for 1942, 1943, 1944, and 1945, seeks to increase this constructive average base period net income. After a thorough consideration of the objections filed to the findings made by the hearing commissioner, we make the following findings of fact. FINDINGS OF FACT. The stipulated facts are hereby found. The Standard Tube Company is a Michigan corporation and is engaged in the business of manufacturing welded steel tubing. During *916 the base period 1936 through 1939 it manufactured tubular parts, such as brake shafts, torque tubes, and steering columns, for the automobile industry. It also produced butted tubes, which did not require welding, and during *111 a portion of the base period it engaged in seamless tube production. Its present address is Detroit, Michigan, but during the years involved herein it was located at Highland Park, Michigan. The company was organized under the laws of the State of Michigan on December 15, 1917, as the American Metal Products Company. In December 1928 the name was changed to Tubeweld, Inc.; in May 1935 it was changed to the Standard Steel Tube Company, and in November 1935 the name was changed to the Standard Tube Company. Petitioner has at all times kept its books and reported for tax purposes on an accrual basis. Its income and excess profits tax returns were filed on a calendar year basis with the collector of internal revenue in Detroit, Michigan. Petitioner filed with the Commissioner of Internal Revenue timely applications for relief under section 722 of the Internal Revenue Code on Treasury Form 991, and claims for refund on Treasury Form 843 for 1942, 1943, 1944, and 1945, claiming relief under section 722 (b) (4). Petitioner's taxable net income or loss, as finally determined, for each of the base period years was as follows: Net income Year (or loss) [1936] $ 79,795.17 [1937] 7,014.84 [1938] (150,827.57) [1939] (355,774.09) On *112 its excess profits tax returns for the calendar years 1940 through 1945, inclusive, petitioner computed its credit for excess profits tax purposes under the invested capital method. The following summary reflects petitioner's actual credit, computed under the invested capital method, the constructive average base period net income claimed by petitioner, and the constructive average base period net income determined by respondent: Calendar year Petitioner's Petitioner's Respondent's actual credit claim determination 1940 1 $ 76,297.82 [1] 1941 1 76,406.54 [1942] 75,621.33 $ 378,836.77 [1943] 71,485.14 304,834.61 $ 91,550 [1944] 71,843.05 304,834.61 91,550 [1945] 71,629.37 304,834.61 91,550 Respondent has agreed that petitioner has established the existence of base period changes in the character of its business within the meaning of section 722 (b) (4) of the Internal Revenue Code of 1939, *917 predicated respectively upon the installation and the abandonment of a seamless tube mill in the base period, a changeover from gas to electric welding, and by reason of the geographic diversification *113 of its sales in new areas and to new customers. Respondent has not agreed that petitioner had any commitments for future changes in capacity for production or operation in connection with the above-agreed section 722 (b) (4) events. George B. Storer was president, general manager, and active operating head of petitioner prior to and throughout its base period. He continued in that capacity until 1943, at which time he joined the United States Navy. He also controlled the majority stock interest in petitioner. Currently, he is chairman of its board of directors. In 1937 Storer prepared plans to reorganize petitioner's operations, with emphasis on greater efficiency. Throughout the base period Storer's salary was paid upon the condition that he assume and pay the greater part of his travel, automobile, entertainment, legal, financial, and secretarial expense. At times, when petitioner's business was not profitable, Storer received no compensation whatsover. The compensation paid Storer during the years 1936 through 1941, in his capacity of president, general manager, and active operating head of the company, follows: Year Amount [1936] $ 11,000.00 [1937] 5,625.00 [1938] 625.00 [1939] 5,375.00 1936-1939 total 22,625.00 1936-1939 average 5,656.25 [1940] 3,535.35 [1941] 22,172.59 Thomas *114 F. Thornton succeeded Storer as president of petitioner in 1943. Thornton first became employed by petitioner in September 1938, at which time he was placed in charge of automotive sales. In 1939 he was elected to the position of vice president in charge of sales; he served as president of the company from 1943 to 1947; and at present he is executive vice president of the company. In 1947 Thornton was succeeded as president of petitioner by S. L. Willis, who has continued in that position until the present time. Willis was initially employed by petitioner in 1943 in the capacity of vice president and remained in that position until he was elevated to the presidency in 1947. Prior to this employment by petitioner, he was connected with Steel and Tubes, Incorporated, a unit of Republic Steel Corporation. Margaret H. Cosgrove has been employed by petitioner since February 1922. She is presently a director and secretary and treasurer of the company. Throughout the base period, she held those same *918 positions with the company, except that at certain times during which H. G. Wall, an attorney, was secretary, she was assistant secretary. Allan E. Connor was comptroller of petitioner throughout *115 the base period and remained in that position until 1944. He came with petitioner in 1929, and his position and duties were of an executive nature. He supervised petitioner's entire accounting system, including its cost accounting department, and he personally performed a large part of petitioner's cost accounting work. Keen competition existed in petitioner's line of business throughout the base period. Petitioner did not refuse any business during the base period. Throughout that time it sought to retain the automotive business which it had, and to obtain new business from that industry. The percentages of petitioner's automotive accounts to its total net sales for the years indicated are as follows: Year Per cent [1936] 90.2 [1937] 91.86 [1938] 74.88 [1939] 71.76 Av: 1936-1939 82.13 Periods of high production tended to substantially increase maintenance cost. At the end of 1938 petitioner faced additional competition and some of the large buyers of welded tubular products had installed or were considering installation of their own equipment. The manufacture of torque tubing calls for the use of the electric arc welding method. Neither the gas process nor the electric resistance method is practical *116 or usable for it. Electric arc welding of torque tubes was of major importance in petitioner's business. During 1938 petitioner had considerable unsold capacity in practically all phases of its business. The record does not disclose at what per cent of capacity petitioner's plant operated during the base period. During 1938 petitioner supplemented its equipment in order to produce a more varied line of products and thereby place its sales organization in a better competitive position. By the purchase of additional roll equipment, it began welding in the heavier gauges, and manufactured such products as conveyor tubing and air heater tubes. In early 1939 petitioner sought to obtain all types of tubing business, except that of a seamless nature. In 1935 petitioner contracted for the acquisition of push-bench equipment, known as a seamless tube mill, from Wellman Seavers Rolling Mill Co., Ltd., England, to be delivered and installed in petitioner's plant in Detroit. Petitioner had thoroughly investigated the seamless tube mill. Several had been successfully operated in Europe and one in the United States. The seamless mill was installed in *919 1936. The total cost was approximately $ *117 530,000, of which approximately $ 103,000 was expended for such improvements and approximately $ 72,000 was spent for tools and dies, and improvements to leased property. In order to obtain funds for the acquisition of the seamless tube mill, the petitioner in 1935 increased its authorized capital. The shares of capital stock were registered with the Securities and Exchange Commission and its shares of capital stock were listed on the Detroit Curb Exchange and New York Curb Exchange. After the recapitalization petitioner realized from the sale of stock, in the years indicated, the following amounts: Year Amount [1936] $ 630,455.90 [1937] 13,000.00 [1938] 97,987.77 Total $ 741,443.67 Petitioner justified the large expenditure for the seamless tube mill by its expectation of producing tubing for the automotive industry at substantially reduced cost and greatly increased volume. In a statement made in an analysis of petitioner's seamless tube prospects by an investment house in Detroit in May 1936, petitioner estimated its 1936 net income would be $ 120,000, its 1937 net income $ 450,000, and thereafter $ 800,000 to $ 900,000 annually. The investment house noted that such increased earnings seemed "almost *118 fantastic." The seamless process was considered an improved manufacturing operation. The purchase and installation in the base period of the seamless tube mill was a major change in petitioner's manufacturing policies. At the time of installation of the seamless tube mill the petitioner relocated its plant at Highland Park, Michigan, and leased from the Ford Motor Company factory building space for the installation of the seamless tube mill and also moved from its previous location about a mile distant all its other equipment and gas welding tube mills and its office to the new leased space, partly in order to be adjacent to the seamless tube mill. In the seamless tube process of manufacturing operations a square steel billet, about 6 inches square, is heated to a cherry-red heat. From the furnace the billet is put into a hydraulic press which in turn makes the hot billet into a thimble in that it is rounded out and has a cavity. While the billet is still hot, a mandrel is inserted in the cavity of the thimble, and pushed through a series of ring-bed dies, making a tube 18 to 20 feet long. That tube, still hot, is taken off the ring-bed, the fishtail and nose ends are cut off, and *119 the tube sent to *920 the reducing furnace and reducing mill and other fabricating operations. The seamless tube mill was first operated from March 1937 to November 1937, at which time it was shut down due to operating difficulties. The petitioner had difficulty producing a tube which was within the tolerance of wall thickness and would withstand the required pressures. Salesmen of the petitioner's products sometimes had difficulty selling the seamless tube. The walls were sometimes eccentric in that one side would be thinner than the other. The Ford Motor Company in 1938 objected to the eccentricity of the walls of the seamless tube as not being satisfactory for Ford's product. Certain billet furnaces which had been installed in connection with the seamless tube mill were found to be unsatisfactory and were abandoned in 1937. At the meeting of petitioner's board of directors held on October 4, 1937, Storer led a general discussion of petitioner's business, "with particular emphasis upon the operation of the seamless tube mill." On November 26, 1937, petitioner's board of directors decided to suspend operations of the seamless tube mill until further studies could be made. In the annual *120 report to its shareholders for the year ended December 31, 1937, Storer stated: "your Management feels that the defects in the seamless mill have been largely eliminated," and that "with the addition of very little equipment and a new furnace, our mill can be made to operate on a very profitable basis." Following the advice of the Pennsylvania Industrial Engineers, Incorporated, petitioner purchased a new furnace for its seamless tube mill in 1938. Final payment for the furnace was not to be made until it was operating satisfactorily. On March 8, 1938, its board of directors decided to hold in abeyance the purchase of additional equipment for its seamless tube mill, until the sales outlook of that department warranted such expenditures. After installation of new billet-type heating furnaces, operations were again resumed in July 1938 and thereafter permanently discontinued in November 1938. In a letter to its stockholders, petitioner noted that its over-all operating loss in 1938 was due in part to the "inability to secure sufficient volume of business to operate our seamless mill profitably." Petitioner further stated that "we will not operate our seamless mill until we have sufficient *121 contracts to definitely assure profitable operation." The letter also stated: Doubtless a great many of our stockholders wonder what prompted the decision to shut down the seamless tube mill. The answer is as follows: 1. Demand for seamless tubing is extremely low. Existing mills are operating at a fraction of capacity. *921 2. Our ability to produce heavy gauge welded tubing of excellent quality, comparing favorably with seamless tubing, at a very much lower cost has made it more profitable to use welded tubing. A tube welding unit costing $ 10.00 per hour to operate can make an equal amount of tubing as can be produced on the seamless mill costing $ 100.00 per hour to run. 3. A large customer, located in the Detroit area, discontinued the use of seamless tubing, through the use of centrifugally cast steel axle housings. Thus tonnage was the backlog of the seamless mill. Without a basic backlog tonnage to absorb overhead costs it is impossible to operate such a mill profitably. There is used a large tonnage of seamless tubing in the United States for oil wells, boilers, condensers, and oil refining plants. Our Seamless plant will require additional expenditure to manufacture this type *122 of product due to the demand for greater single lengths. Our mill will produce tubes 15 feet 6 inches long, whereas the requirements are for 26 feet lengths. This involves an expenditure of $ 75,000, which we are not prepared to make. Likewise competitive conditions make it imperative to install electric furnaces for making our own steel for use in the seamless mill at an additional cost of $ 150,000.00. In the annual report of the accountants, Ernst & Ernst, for the year 1937, the following statement appears: "In March, 1937, the company completed the installation of a seamless tube mill of the push bench-type and placed it in operation; however, due to difficulties encountered with the new manufacturing process, production of seamless tubing was limited to a comparatively small quantity and operation of the mill was discontinued in November 1937. The management has informed us that since that time it has made a thorough investigation of the operating defects in the new process and as a result of such investigation changes in the equipment are being planned which are expected to eliminate the difficulties previously encountered." A similar statement was made in the report to stockholders *123 for 1937, with a further statement that the petitioner's president had made a trip to England for the sole purpose of investigating the operation of similar seamless tube mills. The seamless mill was sold in 1939 at a capital loss of $ 303,066.70. This amount, together with cost of equipment abandoned, totaled $ 304,566.70. The following summary reflects the gross loss suffered by petitioner from the operation of its seamless tube mill, as indicated by its books, after an allocation of manufacturing expenses by its management, as shown in "Reports of Examination" by Ernst & Ernst, petitioner's outside auditors: March to November July to November [1938] Net sales $ 132,404.29 $ 131,092.90 Cost of goods sold 380,530.06 198,353.17 Gross loss ($ 248,125.77) ($ 67,260.27) *922 A $ 15,000 inventory reserve established December 31, 1937, increased the loss for 1937 by that amount, and decreased the loss for 1938 by a similar amount. Petitioner's administrative and selling expenses were never segregated by products on its books. Petitioner's treasurer and secretary, Margaret H. Cosgrove, upon her knowledge of the business, made allocations to seamless tube mill operations of charges on the books for expenses *124 and to selling and administrative expenses. She is in charge of petitioner's books, accounts, and accounting system, and has a comprehensive knowledge of petitioner's operations. She is familiar with executives' salaries and duties during the periods in question. The selling and administrative expenses originated in the office adjacent to Margaret Cosgrove's. There was no production of seamless tubes in 1936 and no sales, but the selling department was trying to create a market for seamless products. The Tax Court, in a prior case, made a net adjustment to the seamless tube loss for the year 1939, reducing it by $ 8,245.44 for a furnace abandoned in a prior year; which reduces the 1939 loss from $ 326,811.28 to $ 318,565.84. Depreciation for 1939 was disallowed to the extent of $ 419.33. Petitioner's total administrative expenses would not have been substantially reduced during the base period if the seamless tube operations had not transpired. Moving and rearranging expenses included nonseamless as well as seamless facilities. The listing of the class B stock was never deducted by petitioner as an expense in its tax return. For several years prior to and during 1935 the petitioner *125 sold 80 per cent of its production to one automobile manufacturer in the Detroit area. During the base period years the petitioner determined on a program to establish sales agencies and thus to diversify its customers. A sales manager at an annual salary of $ 10,000 was employed in January 1937 as director of sales and in charge of establishing and creation of agencies. In 1937 it was the policy of the petitioner to establish a reputation for the sale of its products throughout the United States and one by one the agencies were added and given territories. During the years 1936 through 1941, inclusive, petitioner, in its sales, was represented by Norwood, Schroeder, Heffron, Wilhemy, McCullough, Grace, Reiger, Standard Tube Sales Corporation, Fijux, Eden, Parsons, Lapham-Hickey Co., Emanuels, Garnjost, Hely, and National Steel Sales. Norwood first represented petitioner in 1929 and continued into 1939. He operated in Detroit on a commission basis, and had a personal contact and arrangement with the Ford Motor Company. *923 Schroeder was a sales engineer who had a connection with the Ford Motor Company. He also represented petitioner in its business with that company, commencing in 1935. *126 He was paid a commission which was charged to petitioner's commission account. It was regarded as a "finder's fee." He had offices located in the General Motors Building in Detroit. Wilhemy was located in Cleveland, Ohio. He represented petitioner as early as 1936. McCullough was located in Toledo, Ohio, and he represented petitioner only in regard to the account with American National Company. His only sales on petitioner's behalf were in the year 1937, and totaled $ 3,763.92. Grace's territory was part of the State of Ohio, and he began representing petitioner in 1937 and continued his representation throughout the remainder of the base period. Reiger's territory was the vicinity of Chicago. He also began representing petitioner in 1937 and continued his representation throughout the base period. Standard Tube Sales Corporation was formed November 1, 1937, by Frank J. Boehm and William F. Grannaman. There is no stock relationship between it and petitioner, although there has always been a close personal relationship between the officers of the two companies. During the base period the Standard Tube Sales Corporation represented petitioner in 14 eastern States and at times was heavily *127 indebted to petitioner. It was not until subsequent to the base period that the indebtedness was satisfied. Fijux was a representative of petitioner in southeastern Michigan during the latter part of 1937 and throughout the year 1938. He made no sales for petitioner's account during 1939. Eden became associated with petitioner in 1938. His original contract limited him to representing petitioner in regard to sales to the Fisher Body Company and any of its branches and subsidiaries wherever located. Subsequently, he also made sales to Motor Products and Hudson Motor Company on petitioner's behalf, but by far the substantial portion of his sales was to Fisher Body Company. He was on a commission basis. Eden's office was located in downtown Detroit, and the headquarters of Fisher Body Company was also in Detroit. The latter company produced bodies for the automotive industry. Parsons only represented petitioner during a few months in 1938 in the Minneapolis and St. Paul area. Heffron was employed by petitioner in February 1938, and was petitioner's western sales manager located in Chicago. He worked directly under V. O. Johnstone, petitioner's director of sales. Heffron worked entirely *128 on a salary basis. His sales were separately segregated on *924 petitioner's journals in the same manner as were sales made by petitioner's agencies compensated on a commission basis. In 1939 he became associated with Lapham-Hickey Company, when it became petitioner's principal Chicago area representative. National Steel Sales became an agency in about June 1939 but made no sales until 1940. No new agencies began representing petitioner after 1939. The following schedule summarizes petitioner's total sales through the above-named representatives, as reflected by its books, for the years 1936 through 1941: Standard Tube Company Total Sales, Per Petitioner's Books Agency [1938] Norwood 1*129 $ 389,650.24 $ 420,101.76 $ 53,292.46 Schroeder 191,100.97 230,357.47 122,692.54 Wilhemy 2,237.92 20,112.39 21,884.46 McCullough 3,763.92 Grace 2,011.63 54,962.92 Reiger 11,626.04 64,161.14 Standard Tube sales 6,167.85 39,621.37 Fijux 3,898.38 18,384.38 Heffron 61,551.02 Eden 72,330.98 Parsons 530.16 Lapham-Hickey Emanuels Garnjost Hely National Steel sales Totals $ 582,989.13 $ 698,039.44 $ 509,411.43 Summary of Chicago area sales totals (as above) (Reiger, Heffron, and Lapham-Hickey Co.) $ 11,626.04 $ 125,712.16 No. of representatives [10] Standard Tube Company Total Sales, Per Petitioner's Books Agency [1941] Norwood Schroeder $ 80,837.14 Wilhemy 31,946.00 $ 3,734.24 $ 3,840.04 McCullough Grace 82,650.62 211.14 Reiger 58,873.96 52,024.00 78,208.25 Standard Tube sales 48,086.69 163,308.21 198,168.08 Fijux Heffron Eden 124,322.83 166,822.34 323,694.91 Parsons Lapham-Hickey 63,415.78 115,947.50 318,501.98 Emanuels 9,532.10 37,005.16 26,058.46 Garnjost 8,044.99 Hely 12,357.27 40,815.43 75,188.22 National Steel sales 28,039.11 11,421.62 Totals $ 520,067.38 $ 607,907.13 $ 1,035,081.56 Summary of Chicago area sales totals (as above) (Reiger, Heffron, and Lapham-Hickey Co.) $ 122,289.74 $ 167,971.50 $ 396,710.23 No. of representatives [8] The number of selling agencies and the agency sales for 1936 through 1941 resulting from petitioner's above-mentioned base period program to establish new sales agencies and to diversify its operation were as follows: Year Agencies Sales [1] $ 2,237.92 [6] 47,580.21 [7] 199,544.43 [8] $ 314,907.41 [8] 441,084.79 [7] 711,386.65 Agency sales for 1938 and 1939 were welded tubes and fabricated welded tubes. In selling through either jobbers or sales agencies outside of the Detroit area, petitioner paid approximately 5 per cent commissions. The new sales agencies took over some of the jobber business. At times agency commissions were 7 1/2 per cent. *925 Petitioner sold on a basing point system in 1938 and 1939. Detroit was a basing point. In 1939, in order to meet competition, it absorbed $ 12,000 of freight expenditure by reason of the basing point system. Basing point sales were generally through its sales agents. In a letter dated August 8, 1939, to Lapham-Hickey Company, one of its new agents, petitioner stated: We have at the same time attempted to arrive at the middle course procedure, which would tend to make the sale of our tubing and tubular products attractive to your company, *130 and at the same time, attractive and profitable to us, which in the past, unfortunately, has not been the case. Petitioner, prior to and during the base period, produced welded steel tubing by a gas welding process using oxygen-acetylene, and by electric arc welding. It also produced the above-mentioned seamless tubes in 1937 and 1938. Except for the manner by which the edges are united, the gas welding process and the electric resistance process are similar in that both start out with a coiled strip which has been rolled or slit to approximately the circumference of the finished tube; the tube is formed by a series of contouring rolls progressing from flat, to "U", to round. A resulting open cleft in the seam of the tube is fed under the welding medium where it is united. It subsequently goes through sizing and straightening rolls, and is then cut off. Welding by a gas torch is the earliest form of welding, and originally it was combined oxygen and hydrogen. When acetylene became commercially available, an oxy-acetylene torch was devised which produced a flame of much higher temperature, running to some thousands of degrees. Each torch has its mixing device in which the gases *131 are combined in proper ratios, pressures, and velocities, and proper shaped flames formed. The torch commonly seen in welding operations has one flame, one tip, but in the welding of tubing there is a multiple-type torch having as many as 25 flames in a single torch. In some standard tubes in gas tube welding petitioner used two of those torches in tandem in an effort to produce the proper fusing temperature at a satisfactory mill speed. The control of this oxy-acetylene requires a skilled and experienced operator. A crew on a mill is two men, an operator and a helper. One of the hazards in connection with the gas welding is a toxic gas which forms inside the tube and is exhausted from the outgoing end and has to be ignited or it will asphyxiate the helper. Another hazard is the storage of acetylene tanks. The contrast between electric resistance process of production of welded steel tubes and the gas weld process is that in gas or air weld the metal adjacent to the edges to be welded is heated, whereas, in electric resistance weld, a current of high amperage and low voltage comes through with little resistance until it gets to the point where it hits the metal to be welded. A *132 high resistance causes an extreme *926 heat, at which time the tube is squeezed together. When the metal is squeezed together, it is past the plastic stage in consistency. The electric resistance weld makes stitches in the tube which can be counted by the number of cycles. A 60-cycle current will make 60 stitches in 1 second. Gas welded tubes are in some respects competitive with electric welded tubes, but the latter have the advantage for chrome plating, ornamental uses, vacuum cleaners, automobile pumps, food conveyors for fruit juices and milk, boiler, heat exchanger, and most pressure tubes. Electric resistance welded steel tubes were widely approved for boiler, heat exchanger, and pressure uses. Gas welded tubes were not approved for such purposes. They were sometimes used for air heat pressure tubes. Gas welded tubes are not acceptable for further processing and manufacture where there would be severe strain on the walls. Gas welded tubes have leaks in the seam at the weld. Most of the gas welded tube is formed burr in, that is, the welding flash which occurs on the inside is left there simply because its removal is difficult. This eliminates it for uses as pump tubes and cylinder *133 tubes which have to have a smooth inside diameter; it may collect foreign matter and set up a corrosion angle. Gas welded tube uses include bedsteads, handrails and posts, collars, and spacers. A manufacturer who restricts himself to gas welded tubing is precluded from those fields needing pressure tubes and pump tubes or any kind of tube which has a strict inspection or subsequent fabrication. A patented process of electric resistance steel tube manufacture known as the Johnston process was controlled by Steel and Tubes, Inc. Petitioner negotiated in 1937 and 1938 without success for a license under the Johnston patent. Steel and Tubes, Inc., through control of the Johnston patent, would license the Johnston process, but would not permit licensees to manufacture pressure tubes during 1936 to 1939. The Johnston patent expired November 14, 1939, and, without a license, the patent prevented the petitioner from making electric resistance steel tube under it prior thereto. It was the practice of petitioner to sell on order, not from inventory, and petitioner believed that the Johnston patent prevented it from solicitation of orders prior to November 14, 1939, for tubing made under its *134 teachings. Petitioner's change to the Johnston process was restricted by the existence of the Johnston patent until its expiration November 14, 1939. Petitioner's balance sheets as of dates indicated disclose the following: *927 December 31 [1939] Assets Cash $ 53,833.47 $ 23,430.56 Other current assets 228,122.40 294,611.42 Other assets 6,967.24 9,906.65 Equipment and property improvements 684,775.64 363,152.59 Deferred charges 7,007.47 7,610.55 Total $ 980,706.22 $ 698,711.77 Liabilities Current liabilities $ 223,423.00 $ 224,955.17 Reserve 2,000.00 Notes payable to stockholders 49,800.00 Capital stock and surplus 755,283.22 423,956.60 Total $ 980,706.22 $ 698,711.77 In 1935 petitioner had an American Electric Fusion Welder with forming rolls. In 1937 it received quotations from this and another maker of electric welding equipment. The petitioner gave consideration to electric resistance welding during the base period. The petitioner had engineering drawings prepared in 1939, and in 1937 and 1939 secured quotations from suppliers of equipment. Electric resistance welding mills have an estimated life of 12 years for depreciation deduction purposes. As of December 31, 1938, petitioner's books disclosed $ 6,300 for two incompleted *135 work orders for electric welding machines which were being developed but were to a point where they had been used to some extent and were regarded as proper capital additions. As of December 31, 1939, petitioner had 7 tube welding mills, the functions and histories of which were as here indicated: Mill No. Type on Dec. 31, 1939 [1] Gas welding. Improved by 1939 expenditure of $ 6,926.29. Converted to electric resistance process by Jan. 1941. Scrapped in Oct. 1942 as obsolete. [2] Gas welding. [3] Electric resistance welding. Converted from gas by Oct. 1939 at cost of $ 11,572.26. [4] McKennie tube former, which was a type of electric resistance welding since 1938. Electric welding units installed by Aug. 1940. Rolls installed in 1940. [5] Gas welding. Scrapped in Oct. 1942 as obsolete. [6] Electric resistance. Complete electric welding fixture by May 1939, costing $ 2,216.51. Had been experimental. Scrapped in Oct. 1942 as obsolete. [7] Electric arc welding. $ 33,197.98 expended on mill and rolls by Dec. 1939. Converted to electric resistance welding by April 1941. Petitioner expended about $ 47,000 for electric welding equipment during 1939 through 1941. This was inadequate to cover the cost of completely converting *136 its 7 mills to the electric resistance welding process. *928 The petitioner generally priced its gas welded steel tubing during the base period at a price differential 5 per cent less than electric welded steel tubing. In some instances this price differential gave it a competitive advantage. In 1939 in letters to its west coast agent 3 per cent differential was noted. In 1939 its price for irrigation tubing was the same as quoted by Steel and Tubes, Inc., the Republic Steel Corporation subsidiary. Electric resistance welding process is faster than the gas welding process. Petitioner's production standards for gas weld mills in feet per hour, by tube size and gauge, are set forth in its Exhibit 6, and are incorporated in these findings by this reference. These standards were used by petitioner during the base period for cost, standard, and payroll bonus calculations. Charts showing production standards in feet per hour, by tube size and gauge, for electric welding mills were similarly prepared by the comptroller for the petitioner in late 1939, and were used by petitioner in 1940, 1941, and 1942. Speeds were never changed. They are set forth in Exhibit 7 and are incorporated in these *137 findings by this reference. As mills were converted speed standards would be applied to each mill. It was common practice for petitioner's employees to exceed these production standards. The petitioner produced and sold welded steel tubing as follows: Year Feet [1936] 7,114,700 [1937] 13,555,980 [1938] 8,199,460 [1939] 11,257,412 [1940] 23,425,482 [1941] 35,720,690 A summary of petitioner's base period sales, by products, as reflected by petitioner's books, is as follows: Products [1938] Torque tubes 1 $ 484,879.46 $ 598,275.19 $ 149,712.15 Welded tubes 211,439.78 513,223.11 357,260.39 Fabricated welded tubes 91,771.19 154,242.41 92,503.32 Butted tubes 299,310.76 472,063.27 194,849.57 Lumber products tubes 2*138 54,480.19 38,048.52 2,221.69 Seamless tubes 132,810.22 126,600.33 Fabricated seamless tubes 5,879.99 Miscellaneous 33,380.58 3,369.78 Totals $ 1,175,261.96 $ 1,912,032.50 $ 929,027.44 Products [1939] Total Torque tubes 1 $ 397,162.55 $ 1,630,029.35 Welded tubes 478,317.66 1,560,240.94 Fabricated welded tubes 234,930.46 573,447.38 Butted tubes 200,783.15 1,167,006.75 Lumber products tubes 2 94,750.40 Seamless tubes 259,410.55 Fabricated seamless tubes 5,879.99 Miscellaneous 36,750.36 Totals $ 1,311,193.82 $ 5,327,515.72 Petitioner, during the base period, did not manufacture or sell any of the following: Pig iron, steel, machinery, lumber, furniture, stone, clay, and glass products, nonferrous metal and products produced by smelting, refining, or fabricating, all being components of the Durable Goods Index. *929 The components of the Durable Goods Index published by the Board of Governors of The Federal Reserve System, as computed from the data published in Federal Reserve Index of Industrial Production, are as follows: Durable manufactures Per cent 1. Iron and steel 29.00 2. Machinery 28.50 3. Transportation equipment (automobiles is 12.63 per cent) 15.61 4. Lumber and products 11.52 5. Stone, clay, and glass products 7.91 6. Nonferrous metals and products 7.41 100.00 The indexes compiled by the Board of Governors of The Federal Reserve Board and published in the 1942 supplement, "Survey of Current Business," the United States Department of Commerce, were used to determine the two parts of the Durable Goods Index which make up the segment of 12.63 per cent, and are as follows for the years 1936 to 1941, inclusive: Index of Industrial Production of Automobile Transportation Equipment Automobile Automobile Automobile transportation Year bodies, parts, factory equipment and assembly sales 1935-1939 = 100 1*139 1935-39 = 100 2 1939 = 100 3 [116] 115.0 122.99 [125] 123.0 131.55 [65] 66.0 70.59 [93] 93.5 100.00 [116] 116.0 124.06 [126] 133.0 142.25 A summary of the sales, profits before income taxes, and the percentage of those profits to sales of the motor vehicle parts and accessories industry, for the years 1936 through 1943, as reflected by the Office of Price Administration War Profits Study No. 16, being a study of 2,500 leading industrial corporations by major and minor industry groups, with O. P. A. "Financial Report," Moody's "Industrials," and Standard and Poor's "Corporation Records," as source material, is as follows: *930 Net sales Profits before Per cent -- Year (Table 3) income taxes profit to (000 (Table 1) sales omitted) (000 omitted) [1936] $ 583,297 $ 56,319 9.7 [1937] 671,323 55,142 8.2 [1938] 380,370 2,936 .8 [1939] 476,554 41,200 8.6 [1940] 635,658 79,442 12.5 [1941] 1,042,543 166,176 15.9 [1942] 1,549,661 213,868 13.8 [1943] 2,428,060 279,224 11.5 1936-1939 av 527,886 38,899 7.4 Petitioner's *140 14-year history of sales, income, and capital from 1922 through 1935 appears in joint Exhibit 2-B, heretofore incorporated in these findings by reference. It indicates its average earnings to sales to be .34 per cent; its average earnings to capital to be 30.71 per cent; its average on income dollar to sales dollar to be 7.01 per cent; and its average of capital and surplus or deficit at the beginning of the year to be $ 143,917.65. Petitioner has failed to establish that it is entitled to any increase in the constructive average base period net income allowed it by respondent. OPINION. Petitioner's actual average base period net income was a loss figure of $ 104,947.91. 1 Respondent admits that the elimination during the base period of petitioner's seamless tube mill, the addition of new agencies to diversify its customers and geographic area, and the change to an electric resistance welding process for its tube manufacture constituted qualifying factors under section 722 (b) (4) of the Internal Revenue Code of 1939, and has allowed petitioner a constructive average base period net income of $ 91,550 for 1943, 1944, and 1945. Petitioner had computed its excess profits tax credit on *141 the invested capital method which entitled it to a credit varying between $ 72,000 and $ 76,000 during the years 1940 through 1945. Petitioner now claims that it is entitled to a constructive average base period net income under section 722 (b) (4) of $ 239,642.83 "for the first excess profits tax taxable year" and $ 273,342.23" for the second excess profits tax taxable year." After a thorough consideration of the record, we believe that petitioner has not established its right to any increase in the $ 91,550 constructive average base period net income allowed by respondent. Petitioner has justified some adjustment to its average base period net income, but it falls far short of the constructive average base period net income which respondent will allow. *931 SEAMLESS TUBE MILL LOSSES. Petitioner, early in its base period, acquired and put into operation a seamless tube mill from which it had expectations of large profits. Troubles developed in the mechanical operation of the mill and in obtaining orders in sufficient quantity to justify its operation. The mill was closed down in 1938 and sold before the end of the base *142 period at a substantial loss. Petitioner would adjust its base period income by seamless tube mill losses to be eliminated as follows: [1936] ($ 33,773.20) [1937] (299,389.26) [1938] (131,343.15) [1939] (318,565.84) Respondent computes such adjustments to be as follows: [1936] ($ 1,986.18) [1937] (238,910.79) [1938] (95,193.10) [1939] (318,092.35) Petitioner's computation of losses is from book figures and allocations of pertinent items between seamless and nonseamless business. Although these allocations were made by a witness long associated with petitioner, its operations and its books, her method of charging to the seamless tube operation various expenses which existed or continued with petitioner whether the seamless tube mill was being operated or not, cannot be accepted. Whatever its merit for cost accounting purposes, we see no justification for making an adjustment which is so far removed from realities in arriving at a determination of what is petitioner's normal base period income. We conclude upon the entire record that petitioner is entitled to an adjustment to its average base period net income on account of its seamless tube losses in an amount less than that claimed by petitioner and larger than *143 that computed by respondent. Even if we accepted petitioner's adjustment for seamless tube losses, the constructive average base period net income would still be less than the $ 91,550 which respondent will allow. Diversified Sales Agencies Profits. Considerable dispute as to the facts relating to this issue have been resolved in the findings. Only a few of them are crucial to our conclusion. Petitioner appears to argue this issue as though it involved a commitment for a future change in capacity, but there is no basis upon which the commitment rule could operate. Factually the number of agencies did not increase after 1939. *932 Petitioner contends that the facts disclose considerable growth of the agency business between 1938 and 1939 as compared with the growth of other sales, and that this is an appropriate occasion for the application of the "push-back" rule provided by the statute. Respondent urges that petitioner's position is fallacious by reason of petitioner including in its other business all of its Detroit area sales which comprised home office sales and sales by agents operating in the Detroit area. We do not believe there could be any doubt that petitioner had "agencies" *144 in the Detroit area. However, these existed prior to and continued during the base period. They were not part of petitioner's 722 (b) (4) change in its method of doing business by representation by agencies in widespread geographic areas. For this reason we hold that the treatment of the Detroit agencies, including Eden, must be grouped for comparative purposes with all of its Detroit area sales. It is the new agencies with which we are concerned. Respondent, in an effort to show that petitioner's reconstruction of this item would result in no benefit, takes the position that the 1938 seamless tube sales must be eliminated for the purposes of ascertaining the 1939 increased percentage of growth attributable to the new agencies. The new agencies in 1938 and 1939 sold only welded and fabricated welded tubes; and we have already accepted petitioner's position that the seamless tube business resulted in losses in the base period years. A recomputation with the seamless tube sales eliminated, does not establish petitioner's crucial premise that there was a greater percentage increase of 1939 new agencies sales over those for 1938 than existed in a similar comparison of Detroit area *145 sales. It would demonstrate the fact that by 1939 petitioner had developed its full potential of its agency geographic diversification program. The equity of eliminating the seamless tube losses at this stage of the reconstruction is but one example of the difficulties presented in this issue. Others equally difficult relate to the fixing of an appropriate percentage of income to sales, and the choice of an appropriate index for backcasting, bearing in mind petitioner's own base period history of losses. But these problems need not be resolved because in our judgment the record is replete with strong factual material that leads us to conclude that the new agency sales were not profitable, nor did they have prospects of being profitable. It is demonstrated that the new agency sales had extra expenses of freight and commissions incident to them; and the elimination of the seamless losses still left petitioner with substantial losses in 1938 and 1939, which are not shown not to have been attributable to the agency sales. Such a showing would indicate that if any increase in agency sales was to be reconstructed, the result would be an increased loss rather than increased profits. *146 Petitioner has not established it is entitled to any greater relief by reason of *933 having had a section 722 (b) (4) change in its method of doing business by the introduction of diversified agencies. Electric Resistance Welding. Here again petitioner seeks to make its case on a commitment during its base period to increase its capacity under its qualifying change after the base period and make its reconstruction on the basis of the post base period increased facilities. In a proper case, this can be done under the provision of section 722 (b) (4), which reads as follows: SEC. 722 (b) (4). * * * 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, * * * shall be deemed to be a change on December 31, 1939, in the character of the business, * * * Petitioner contends that the pleadings place respondent in the position of having admitted that petitioner had a "commitment" with regard to its electric resistance welding qualifying factor. In connection with the change to electric resistance welding, petitioner, in *147 paragraph 5 (h), alleged that respondent "erred in failing to make allowance as claimed under the commitment and push-back rule in the reconstruction of the base period income for the determination of an excess profits tax credit under section 722, for the amount of additional base period income for the change from gas weld process to the electric weld process of the production of welded tubes." In his answer respondent denied that he had erred as alleged. In paragraph 6 of its petition, petitioner relied upon the following facts: "(f) The respondent and the Excess Profits Tax Council have conceded that the petitioner has established existence of a qualifying event under section 722 (b) (4), resulting from the program adopted prior to December 31, 1939, and to which petitioner was committed, for the changeover from gas to electric welding." In his answer respondent, with reference to paragraph 6 "(e) to (h) inclusive" stated "admits the allegations of fact contained in subparagraphs (d) to (h) inclusive of paragraph 6 of the petition." At the commencement of the hearing, the parties discussed the state of the pleadings, at which time respondent took the position that his admission of *148 the factual allegations in paragraph 6 (f) of the petition might be subject to misinterpretation, but that he never intended to admit in his pleadings that the petitioner had any commitments for any future changes in capacity for production or operation within the meaning of section 722 (b) (4) and leave was given for him to file an amendment to answer wherein he averred "that neither respondent nor the Excess Profits Tax Council recognizes or has ever recognized a commitment by the petitioner for a change in capacity for production *934 or operation, as defined in the last sentence of section 722 (b) (4) of the Internal Revenue Code, based upon petitioner's changeover from gas to electric welding." Respondent further alleged that the Excess Profits Tax Council had determined that the change from gas to electric welding, which petitioner actually accomplished in 1939, constituted a "change in character" and that any reconstruction based upon this change in character must be based on petitioner's business as constituted on December 31, 1939, and not upon a commitment for a future change in capacity. Petitioner's reply to respondent's amendment to answer was that petitioner was without knowledge *149 as to the truth of the averments, denied them, and demanded strict proof thereof. We view the pleadings as constituting no concession by the respondent that petitioner was committed to a change in capacity for production or operation within the meaning of section 722 (b) (4). We believe that in nowise has the present state of the pleadings shifted a burden of proof as to the existence of such a commitment from petitioner to respondent. Respondent has always denied that he erred in failing to make allowance as claimed under the commitment and push-back rule in reconstruction of petitioner's base period income. He has made no affirmative allegations which require proof on his part in order to sustain this position. At the time of the hearing, inquiry was made of petitioner's counsel as to whether the filing of the respondent's amendment to answer entailed any surprise or required a continuance in order for him to proceed with his case. The reply was in the negative. In our judgment, petitioner has not demonstrated that it was committed to a change from gas to electric welding after the base period. Petitioner's evidence does show that it was interested in the electric resistance welding *150 process but the evidence falls short of a well established intention to make the conversions urged by petitioner. Moreover, the facts demonstrate only a very limited conversion. There are further reasons why petitioner cannot prevail on this issue. Petitioner makes its entire reconstruction on the premise that its reconstructed capacity would have permitted it during the base period to sell electric resistance welding tubing to its customers in equal amounts as it had sold them gas welded tubing. When it is recalled that the gas welded tubing had sufficed for the purpose for which it was sold and, perhaps more to the point, that gas welded tubing sold for 5 per cent less than electric resistance welded tubing during the base period, except for 1939 when the differential was 3 per cent, it is incredible to conclude that comparable sales of electric resistance tubing could have been made. Although electric resistance welded tubing had possible advantages over gas welded tubing, these *935 advantages did not concern those who were already using the gas welded product. There is no showing as to the extent of availability of customers for the new products, other than those who were already *151 satisfactorily using the old product. The automobile business is an example of the highly competitive field in which petitioner was engaged and such a price differential would be crucial. At least petitioner made no effort to prove the contrary; and we are not able to assume that petitioner's premise is correct. This Achilles' heel to petitioner's case can lead to no conclusion other than that relief on this factor cannot be granted. In view of the foregoing, our conclusion must be that petitioner has not justified any increase in its constructive average base period net income by reason of its claims relating to the change from gas welding to electric resistance welding. Our over-all conclusion is that the petitioner has not established its right to any effective relief and that the relief already granted to petitioner by respondent is generous. Respondent concedes that this Court's holding in Nivison-Weiskopf Co., 18 T. C. 1025, eliminates its application of E. P. C. 29 (1948-1 C. B. 90), which had caused respondent to limit petitioner's excess profits tax credit for 1942 to its invested capital credit. But respondent contends the limitation should still be made by reason of *152 his application of the variable credit rule. That rule is of moment primarily in commitment cases or situations where the change was immediately before the end of the year, and we have concluded that there is no such situation here which would result in any relief. In this posture of the case, since petitioner has failed to justify a constructive average base period net income in excess of that allowed to it by respondent, we leave this case as we found it. Petitioner is granted no increased constructive average base period net income. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. For carryover purposes only. No claims for refund.↩ 2. No allowance was made because of application of variable credit rule and E. P. C. 29.↩ 1. From transcript. 1. Torque tubes are electric arc welded.↩ 2. A particular size of gas welded tube. 1. Compiled by the Board of Governors of The Federal Reserve System and published in the 1942 Supplement -- Survey of Current Business, United States Department of Commerce, p. 8. 2. Average of the two component indexes in the preceding columns which, together, make up the Automobile Transportation Equipment segment of the Index of Industrial Production.↩ 3. Data in the preceding column divided by 93.5 and multiplied by 100.↩ 1. ↩ [1936] $ 79,795.17 [1937] 7,014.84 [1938] ($ 150,827.57) [1939] (355,774.09)