Franks Mfg. Corp. v. Commissioner

Franks Manufacturing Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent Franks Mfg. Corp. v. Commissioner Docket No. 35969 United States Tax Court 27 T.C. 507; 1956 U.S. Tax Ct. LEXIS 19; December 12, 1956, Filed *19 Decision will be entered under Rule 50. Changes in the types of oil well drilling and servicing equipment manufactured by petitioner held a change in the character of the business under section 722 (b) (4), I. R. C. 1939, and a constructive average base period net income determined. Donald P. Moyers, Esq., and John H. Conway, Esq., for the petitioner. Allen T. Akin, Esq., for the respondent. Withey, Judge. WITHEY *508 This proceeding involves claims for excess profits tax relief under section 722, Internal Revenue Code of 1939, for the years 1940 to 1945, inclusive, in the following amounts: Relief under Year section 722 [1940] $ 70,815.76 [1941] 119,264.16 [1942] 90,605.29 [1943] 77,384.66 [1944] 95,427.27 [1945] 39,505.09 *20 Respondent has determined that petitioner's excess profits credit for 1941 of $ 7,965.10, computed under the invested capital method, is an inadequate standard of normal earnings, and that petitioner is entitled to the use of a constructive average base period net income of $ 8,700. The claims for the other taxable years involved were disallowed in whole for the reason that the excess profits credit resulting from the use of the constructive average base period net income of $ 8,700 would not produce a credit in excess of that computed under the invested capital method. In his notice of deficiency and partial allowance of petitioner's claims, respondent determined excess profits tax deficiencies of $ 9,805.36 for 1941; $ 23,513.47 for 1942; $ 29,647.05 for 1943; and $ 5,410.74 for 1945. By an amendment to his answer, respondent alleges that there are additional deficiencies in excess profits tax for 1942 and 1943 in the respective amounts of $ 44,626.48 and $ 32,251.64, due to deferment of tax under section 710 (a) (5), Internal Revenue Code of 1939. FINDINGS OF FACT. The petitioner is an Oklahoma corporation with its principal office located at Tulsa, Oklahoma. Its returns for*21 the years involved were filed with the collector of internal revenue for the district of Oklahoma. The petitioner was organized in December 1934 as the successor of a partnership, Franks Manufacturing Company. The former partners, H. H. Franks and Carl White, Jr., became petitioner's principal officers and stockholders, each receiving 2,704 shares of petitioner's capital stock. Other stockholders were: George S. Bays, who received 1,091 shares, and Fern Mason who received 1 share. Franks served as petitioner's president until his death in 1945. White was vice president until Franks's death, when he became president. The predecessor partnership was formed by Franks and White in 1931 to manufacture oil well servicing equipment. Franks was a master mechanic who had been employed by Tidewater Oil Company. White was a mechanical engineer and a graduate of Yale University. He had been employed for a number of years by Lucey Manufacturing Company, *509 a manufacturer of oil well drilling equipment. The partnership's operations were begun in a shop rented from Tidewater Oil Company. Prior to 1930, White and an associate had developed a portable oil well servicing unit mounted*22 on a truck. With a producing oil well it is often necessary to pull out and clean the pipe and pumping equipment. This requires the use of a derrick or "mast," for lifting the pipe, and special equipment consisting of winches, drums, cables, etc. This equipment is moved from well to well as occasion demands. In some instances the wells have production derricks already in place and in others derricks or masts have to be built. Before development of the truck-mounted portable unit the equipment was transported by tractors. The portable unit was more mobile and permitted the servicing of a greater number of wells at less cost. Masts were later added to the portable units with the other equipment. Until about 1933, the partnership manufactured and sold only well servicing units and spare parts. In that year it began the manufacture of "spudders." A spudder is a complete assembly of the equipment necessary to clean out and remove obstructions from wells and sometimes to deepen them. The complete unit consists of cables, winches, drills, bailers, and other parts, all mounted on a truck chassis. In 1935 petitioner also began the manufacture of "core drills." This was a light portable*23 drill unit mounted on a truck. It was used for shallow core drilling only, and was not suitable for drilling production wells. Oil well drilling is done either by the "percussion" method or the "rotary drill" method. With the percussion, or cable tool method, as it is sometimes called, the hole is formed by a "churn bit" which is forced into the earth and the loose cuttings are removed by suction with the use of a "bailer." With the rotary drill a circular cutting bit is fastened to a steel tube or pipe, and both pipe and bit are rotated by mechanical power applied at the surface. The cuttings are removed from the hole and brought to the surface by a mud mixture which is forced down through the pipe and up to the surface in the annular space between the pipe and the perimeter of the hole. The hole is enough larger than the pipe to allow sufficient space for the mud to flow to the surface. The rotary drill was first used for oil well drilling by Shell Oil Company in 1917. In later years it largely replaced cable tool drilling. Prior to about 1930 a drilling rig was conveyed to the well site in sections and then assembled. There were 12 or more truckloads of necessary equipment*24 and supplies, and the assembling of the equipment required from 2 to 4 weeks. The drilling derricks, usually made of wood, were constructed at the site of the well. *510 During the 1930's steel derricks came into use and largely replaced the wooden derricks. By the middle 1930's some of the manufacturers of oil well equipment were making completely portable drilling rigs, exclusive of derricks, mounted on trucks. A rig of this type known as a "baby rotary" was manufactured by Wilson Manufacturing Company, Wichita Falls, Texas, in the early 1930's. Internal combustion motors supplanted steam engines as a source of power, with a considerable savings in water, a critical item in most areas, and allover costs. The development of these and other cost-saving innovations resulted, in part, from the depression in the oil industry during the 1930's and the efforts of the producers to reduce costs of production. In 1936 petitioner received a request from Phillips Petroleum Company for the design of a complete, portable rotary drill unit, including a derrick, suitable for drilling shallow wells, to a depth of 1,000 feet, at a minimum cost. The first portable drilling units then in*25 use did not contain a derrick. Phillips had a large area which it was developing by what is known as a "secondary recovery" method. By this method the field is pressurized by the injection of water into numerous shallow holes. Petitioner designed such a unit and received an order from Phillips for their construction in January 1937. Units of this type were advertised by petitioner in its 1937 catalog. One of such units was advertised as being capable of drilling to a depth of 3,000 feet. Also, in 1937, petitioner was producing and advertising a portable telescoping derrick. The following were the products listed for sale by petitioner in its catalog for 1937: Truck and skid type winches. Truck and skid type rotary drilling units. Small portable rotary with hydraulic feed. Spudding units with or without sand reel and mast. Portable telescoping masts. At the request of Shell Oil Company, petitioner, in 1937, designed and constructed a complete portable rotary drilling unit, including a derrick, for deep well production drilling. No such rig was in use at that time. The portable units previously developed were designed for servicing producing wells and for core or shallow well*26 drilling. Three such rigs, identified as models 2000, 3000, and 3000A, all designed for "slim hole" drilling to depths of 2,000, 3,000, and 4,000 feet, respectively, with derricks or masts designed to fold down for over-the-road position, were advertised in petitioner's 1938 catalog. "Slim hole" is a term for holes for pipe of less than standard 7-inch size. Holes for the standard size pipe were known as big holes. Slim holes were usually for 4 1/4- or 4 1/2-inch pipe. This type of drilling was introduced by Shell Oil Company about 1936. A large, portable unit mounted on a truck trailer identified as model 5000 was advertised in petitioner's *511 1939 catalog as suitable for slim hole exploration and production drilling to a depth of 6,000 feet. The following items were advertised by petitioner as its principal products in its 1939 catalog: Truck and skid type well servicing winches. Truck and skid type rotary drilling units. Portable rotary drilling units and deep core drills with hydraulic feed. Portable derrick type masts. Spudding units with or without sand reel and mast. Portable telescoping masts. Power takeoffs. The petitioner set up a display of a portable drilling*27 rig at the Petroleum Institute held at Tulsa, Oklahoma, in 1938, and advertised it nationally in the Petroleum World Magazine. It received inquiries regarding these units from a large number of oil producers both in the United States and other countries. Following is a list of the orders received by petitioner for rotary drilling units during the years 1937, 1938, and 1939: Year Ended December 31, 1937 Date of order Customer Model Amount of invoice January 1937 Phillips Petroleum Company 3000 truck rotary $ 9,029.51 June 1937 Sinclair Prairie Oil Company 3000A truck rotary 20,272.64 July 1937 Shell Petroleum Corporation 3000A truck rotary 14,631.00 October 1937 Phillips Petroleum Company 3000A truck rotary 16,937.00 Year Ended December 31, 1938 Date of order Customer Model Amount of invoice February 1938 Phillips Petroleum Company 5000 rotary (trailer mounted) $ 31,879.94 June 1938 Shell Petroleum Corporation A-4000A truck rotary 21,159.00 June 1938 A. y F. Wiese, S. A. 3000A truck rotary 1 39,300.00 July 1938 William Helis 4000AC truck rotary 1 35,991.00 July 1938 Shell Petroleum Corporation A-3000A truck rotary 21,159.00 October 1938 Phillips Petroleum Company 5000 rotary (trailer mounted) 35,158.44 *28 Year Ended December 31, 1939 Date of order Customer Model Amount of invoice March 1939 Shell Oil Company, Inc A-4000A truck rotary $ 21,388.07 April 1939 Phillips Petroleum Company SA-4500 skid rotary 24,523.85 June 1939 Estados Unidos de Venezuela E-4000A truck rotary 1 34,984.00 August 1939 Chickasha Oil Company 3000A truck rotary 2 18,360.00 October 1939 Shell Oil Company, Inc SAL 5000 skid rotary 29,374.94 October 1939 Agey Drilling Company SAL 5000 skid rotary 37,589.40 November 1939 Shell Oil Company, Inc 4000A truck rotary 22,070.89 *512 The early portable drilling units produced by the petitioner were individually designed and built to purchasers' specifications. The different models embodied various changes to correct defects and incorporate improvements indicated by actual usage. Petitioner encountered a great many difficulties and spent a considerable amount of time and money in developing a satisfactory unit. Many of the principal features of the different designs had been standardized by the end of 1939. Standard price lists*29 for its various products were put into effect by petitioner near the close of 1939. One of the products manufactured by petitioner in 1936, and during most of the base period, was a portable telescoping mast used for servicing producing wells which did not have a production derrick. This was a single column of pipe capable of being raised or lowered, with an overhead hoist for rolling the pipe and rods from the hole. Because of its limited height it could handle only single sections of pipe. Later, about March 1939, petitioner developed and put on the market the first portable telescoping derrick to be used in the oil industry. It eliminated the necessity for a permanent production derrick for each well and permitted the servicing of a large number of wells in a given area with the one derrick. The telescoping feature permitted the derrick to be raised to a height of 84 feet, which was sufficient to remove pipes and rods from the well in multiple sections. It also permitted them to be left in a perpendicular position within the derrick. Telescoping derricks were later incorporated in the portable drilling units. Estimates of drilling costs, which petitioner prepared and used*30 in selling its integrated portable drilling units, showed a cost of $ 16,577.78 for drilling and equipping a standard size well in the Kansas area to a depth of 3,300 feet by use of petitioner's portable rotary drilling unit as against a cost of $ 26,314.89 for drilling and equipping the same well with a nonportable unit. Petitioner entered the export market for its products in 1937 and employed an export representative. Its export sales during 1937, 1938, and 1939 were as follows: *513 Date Description Destination Amount [1937] April Senior winch with mast, less truck Peru $ 2,605.62 April Senior winch without mast or truck Peru 2,254.37 May Giant winch with truck Roumania 12,118.33 May Giant winch with truck Roumania 12,118.33 Total $ 29,096.65 [1938] April Senior winch, less truck Peru $ 2,625.68 April Senior winch, less truck Peru 2,625.68 April Senior winch, less truck Peru 2,625.68 July 3000A portable rotary with truck Peru 39,300.00 August 4000AC portable rotary with truck Greece 1 35,991.00 Total $ 83,168.04 [1939] March Senior winch, less truck Peru $ 2,426.55 April Senior winch, less truck Peru 2,426.55 April Senior winch, less truck Peru 2,426.55 April Senior winch and mast Peru 3,757.82 July Senior winch with truck and derrick Colombia 9,148.92 September E4000A portable rotary drilling unit with truck Venezuela 34,984.00 November Senior winch, less truck Peru 3,017.25 November Senior winch with truck and derrick Colombia 9,816.69 Total $ 68,004.33 Grand total $ 180,269.02 *31 Petitioner's sales of well servicing units, spudder units, rotary drilling units, and telescoping derrick units sold during the years 1931 to 1939, inclusive, were as follows: Well servicing Spudder Rotary drilling Telescoping Year unit units units derrick units [1937] 70 (4 export) [1938] 21 (3 export) [5] 6 (2 export) [1939] 20 (7 export) [4] 4 (1 export) 1 2 The following table shows gross sales, by products, of petitioner and the predecessor partnership for each of the years 1931 to 1939, inclusive: *514 [1933] Sales of units Well servicing units: Domestic $ 8,806.25 $ 20,612.00 $ 36,488.41 Export Total 8,806.25 20,612,00 36,488.41 Spudders: Domestic 2,625.00 Rotary drilling units: Domestic Export Total Telescoping derrick units: Domestic Export Total Other: Domestic Export Total Total unit sales: Domestic 8,806.25 20,612.00 39,113.41 Export Total 8,806.25 20,612.00 39,113.41 Spare parts and service Sales -- all products: Domestic 54,005.60 17,947.74 21,483.61 Export Total 54,005.60 17,947.74 21,483.61 Total gross sales Franks products: Domestic 62,811.85 38,559.74 60,597.02 Export Total 62,811.85 38,559.74 60,597.02 *32 [1936] Sales of units Well servicing units: Domestic $ 76,598.48 $ 84,447.43 $ 155,541.13 Export Total 76,598.48 84,447.43 155,541.13 Spudders: Domestic 3,042.60 2,084.18 23,013.99 Rotary drilling units: Domestic Export Total Telescoping derrick units: Domestic Export Total Other: Domestic 10,093.93 5,106.93 Export Total 10,093.93 5,106.93 Total unit sales: Domestic 89,735.01 86,531.61 183,662.05 Export Total 89,735.01 86,531.61 183,662.05 Spare parts and service Sales -- all products: Domestic 28,816.06 53,700.78 36,661.59 Export Total 28,816.06 53,700.78 36,661.59 Total gross sales Franks products: Domestic 118,551.07 140,232.39 220,323.64 Export Total 118,551.07 140,232.39 220,323.64 [1939] Sales of units Well servicing units: Domestic $ 209,829.71 $ 54,354.12 $ 41,920.16 Export 29,096.65 7,877.04 33,020.33 Total 238,926.36 62,231.16 74,940.49 Spudders: Domestic 45,535.86 28,037.07 19,290.08 Rotary drilling units: Domestic 40,597.51 94,470.58 81,070.36 Export 75,291.00 34,984.00 Total 40,597.51 169,761.58 116,054.36 Telescoping derrick units: Domestic 26,730.27 Export Total 26,730.27 Other: Domestic 15,816.00 5,048.00 18,360.00 Export Total 15,816.00 5,048.00 18,360.00 Total unit sales: Domestic 311,779.08 181,909.77 187,370.87 Export 29,096.65 83,168.04 68,004.33 Total 340,875.73 265,077.81 255,375.20 Spare parts and service Sales -- all products: Domestic 48,589.91 70,200.92 67,730.79 Export 3,465.04 3,215.83 29,653.18 Total 52,054.95 73,416.75 97,383.97 Total gross sales Franks products: Domestic 360,368.99 252,110.69 255,101.66 Export 32,561.69 86,383.87 97,657.51 Total 392,930.68 338,494.56 352,759.17 *33 *515 The following is a summary of petitioner's profit and loss statements for the base period years 1936 to 1939, inclusive, as adjusted by revenue agents: [1939] Net sales $ 218,410.69 $ 385,660.50 $ 324,192.20 $ 327,576.28 Gross profit 31,274.65 44,440.47 50,345.59 50,710.19 Total income 33,416.27 48,506.88 56,436.59 67,206.65 Total deductions 34,653.84 49,331.80 56,499.26 76,768.10 Net income (or loss) (1,237.57) (824.92) (62.67) (18,227.21) Petitioner's excess profits net income, excess profits credit, computed on the invested capital method, as determined by the respondent, and excess profits tax paid, for the years 1940 through 1945, the taxable years here involved, are as follows: Year Excess profits Excess profits Excess profits net income credit tax paid [1940] $ 205,575.84 $ 5,971.89 $ 69,341.58 [1941] 430,269.74 7,965.10 208,517.55 [1942] 127,711.49 24,878.78 39,080.66 [1943] 306,459.68 32,430.88 176,958.46 [1944] 130,224.06 29,194.88 77,829.96 [1945] 100,203.75 42,291.10 40,965.32 Petitioner received an order from the Russian Government through Amtorg Trading Corporation in *34 January 1940 for 40 of its portable rotary drilling units. Negotiations for this sale were begun in the summer of 1939. A repeat order for 40 additional units was received by petitioner later in 1940, and another order for 20 units was received after the close of World War II. Petitioner claimed in its excess profits tax return for 1940 that it was entitled to relief, apparently under section 721, Internal Revenue Code of 1939, on account of alleged abnormal income from the above sales to the Russian Government in that year. The statement was as follows: This taxpayer, THE FRANKS MANUFACTURING CORPORATION, is hereby requesting that certain allowances on its Excess Profits Tax be made due to unusual and abnormal income for the year 1940, which this taxpayer contends is attributable to previous years, and the results of which will be reflected adversely in future years. This organization began originally in 1931 as a partnership, and continued thus until December 1, 1934, at which time, for financing purposes, these partners incorporated in the state of Oklahoma under the name of FRANKS MANUFACTURING CORPORATION. The assets of the partnership acquired by the corporation were very *35 small, and were not added to materially until after January 1, 1940. Consequently, it has very little on which to base an invested capital credit on its Excess Profits Tax return, also, it had lost money from the day of its inception until January 1, 1940, and therefore, must disclaim the Excess Profits credit based on income. During the latter part of the year 1939 this taxpayer began negotiations for the manufacture and sale of 40 complete drilling units to the Amtorg Trading *516 Corporation. This contract, however, was not signed and letters of credit established until the early part of 1940. In order to complete this contract and to make deliveries as specified, it was necessary to double the plant and equipment facilities, as is evidenced by schedule "L" on the corporation income tax return. It was also necessary to make certain other changes in the equipment which will decrease the cost of operation while running at capacity, but will tend to increase the cost of operation if allowed to be idle for any period of time. All of this expansion, the purchase of materials for manufacturing these units, and the cost of operation, was financed with borrowed funds. The contract*36 for 40 units was completed during November of 1940, and was completed to the satisfaction of the purchaser and in such a commendable manner that an order for an additional 70 units was given. The taxpayer is now engaged in the manufacture and delivery of these 70 units. From the inception of this corporation in 1934 until January 1, 1940 the corporation had an operating loss of $ 17,851.13. The total sales for this same period amounted to $ 1,416,121.69. Under normal circumstances this amount of sales should have resulted in an appreciable amount of profit for the corporation. Due to the fact, however, that considerable time, material, and other expense was involved in developing and exploiting the product from which the abnormal income was derived, a heavy loss was sustained instead of a profit. The success of the unit and consequently the contract for the sale of these units is directly attributable to the developing and pioneering of this new type of equipment and can definitely be traced to previous years of operation. On the other hand, the order on which the taxpayer is now working is temporary. The possibility of an appreciable increase in domestic business in future *37 years is very slight, yet the increased overhead that will result from this expansion will continue, and the profit that is now being derived from this unusual order will soon be exhausted by the added overhead expense, unless the corporation be permitted to retain as working capital some of the funds that are now demanded for Excess Profits taxes. In view of the foregoing, it is the desire of this corporation, since enlarged plant facilities will require much more working capital than heretofore, since all of the profits derived from the sale of these units has been invested in buildings, material, equipment, and other expansion; since, as at December 31, 1940, its current liabilities more than offset its current assets; and since, as a result of the above, such income tax and Excess Profits Tax as it will be necessary for them to pay, will be paid with borrowed funds, they be granted a claim for a 50% allowance of the net income shown by form #1121 subject to the Excess Profits Tax. During the base period petitioner changed the character of its business by increasing its capacity for production and operation, so that its actual average base period net income became an inadequate *38 standard for the determination of its excess profits tax for the years at issue. A fair and just amount representing its constructive average base period net income is $ 30,000. OPINION. Petitioner's claims for relief are based on section 722 (b) (4), Internal Revenue Code of 1939. It contends that there was a change in the character of its business during the base period *517 years when it began the manufacture and sale of portable rotary drilling rigs and telescoping derricks. Respondent has recognized that petitioner is entitled to have its excess profits tax computed on a constructive average base period net income of $ 8,700, which produces a credit slightly in excess of that computed under the invested capital method for 1941 but less than that for the other taxable years. Respondent stated in his notice of deficiency and partial allowances of petitioner's claims, dated May 10, 1951, as follows: After careful consideration of your applications for relief under section 722 of the Internal Revenue Code filed April 2, 1943 for the taxable years ended December 31, 1940 and December 31, 1941, June 7, 1943 for the taxable year ended December 31, 1942, May 18, 1944 for the taxable*39 year ended December 31, 1943, and June 25, 1946, for the taxable years ended December 31, 1944 and December 31, 1945, it has been determined that, except with respect to the taxable year ended December 31, 1941, you have not established your right to the relief requested. The relief requested for the taxable year ended December 31, 1941, has been allowed in part. * * * * It has been determined that your invested capital credit as computed under section 714 of the Internal Revenue Code is an inadequate standard for determining excess profits tax for the taxable year ended December 31, 1941 but not for the taxable year ended December 31, 1940 and the taxable years ended December 31, 1942 to December 31, 1945, inclusive. Although a constructive average base period net income of $ 8,700.00 would be allowable for the taxable years ended December 31, 1942 to December 31, 1945, inclusive, the amount would not result in tax benefits greater than those obtained under the provisions of section 714 of the Internal Revenue Code. It has been concluded that you were entitled to a constructive average base period net income of $ 8,700.00 for the taxable year ended December 31, 1941. However, *40 in accordance with your request, an excess profits credit of $ 7,965.10 an amount determined under the provisions of section 714 of the Internal Revenue Code, was used in computing your excess profits tax liability for the taxable year ended December 31, 1941 as set forth in this statement. In the opening statements of counsel at the trial of the case, petitioner's counsel asked Government counsel "for the sake of the record, do you view the case as though we were dealing with the reconstruction problem only?", and Government counsel replied, "Yes, primarily." The record does not show on what specific grounds respondent determined that petitioner was entitled to the use of a constructive average base period net income of $ 8,700 in computing its excess profits credit. In his brief, respondent points out that in the statutory notice to petitioner he has admitted a "qualifying change," but argues that petitioner has failed to demonstrate that it is entitled to a constructive average base period net income in excess of that which has been allowed. *518 On these facts, and the further facts found above regarding petitioner's base period operations, we hold that petitioner changed*41 the character of its business during the base period when it began the manufacture and sale of integrated, portable drilling rigs and telescoping derricks and is, therefore, entitled to have its excess profits credit for each of the taxable years computed on a fair and just amount representing normal earnings under the changed conditions. We do not think that there was any change in the character of petitioner's business resulting from petitioner's entering into foreign trade. The large Russian order, which petitioner obtained early in 1940, according to petitioner's own statement, was in pursuance of a change in its sales policy; but all the record shows petitioner would have accepted foreign orders at any time. As a reconstruction problem, our question is: What would have been petitioner's average base period earnings if it had commenced the manufacture and sale of rotary drilling rigs and telescoping derricks 2 years earlier than it did? To gain any relief, petitioner must establish a constructive average base period net income that would result in excess profits credit, computed under the income credit method, in excess of the credit which has been allowed under the invested *42 capital method. Green Spring Dairy, Inc., 18 T. C. 217; Godfrey Food Co., 18 T. C. 1083. Petitioner first began the manufacture and sale of portable rotary drilling units for production purposes in 1937. These were small units to be used for drilling slim holes to a depth of not more than 4,000 feet. They were made to specifications of the purchasers and were mounted on trucks. Petitioner received orders for 4 such rigs in 1937 from 3 different large oil producers at prices from approximately $ 9,000 to $ 20,000. Three of these units were sold in 1937 for a total sales price of $ 40,597.51; 6 in 1938 for $ 169,761.58; and 4 in 1939 for $ 116,054.36. By the end of 1939 petitioner had developed a large portable unit capable of drilling to a depth of 6,000 feet. It had eliminated many of the defects in the early models which had developed with actual field use and had standardized most of the parts of the different models. Also, in 1939, petitioner had developed and put on the market a telescoping derrick for use in servicing producing wells. This type of derrick had several important advantages over the telescoping*43 mast servicing units which petitioner had previously produced. In our opinion, the evidence of record supports petitioner's contention that it would have reached a higher earning level by the end of 1939 if it had begun the manufacture and sale of the complete portable drilling rigs and telescoping derricks 2 years earlier than it did. This would have given petitioner more needed time to work out the defects *519 which developed in actual field use of the new equipment and to promote its acceptance by the oil producers. The evidence convinces us that with 2 years' additional experience petitioner would not only have sold more units of each type but would also have been able to reduce the per unit cost, after elimination of the development expenses. The extent to which these earlier changes would have improved petitioner's base period earnings is necessarily a matter of speculation. In its proposed reconstruction petitioner estimates that with the earlier changes it would have been able to sell in 1939 at least 30 of the portable rotary drilling units and 12 telescoping derrick units. The sales prices and production costs per unit are geared to petitioner's actual 1939 experience, *44 adjusted for various business period indices and price fluctuations. The sales of products other than portable drilling rigs, such as well servicing units, spudders, and core drills, are not reconstructed, but spare parts and service sales are increased to 20 per cent of the reconstructed unit sales of drills and derricks, which is somewhat less than petitioner's base period experience. The final result of petitioner's reconstruction is a constructive average base period net income of $ 248,853.68 for 1940, and $ 298,710.52 for the years 1941 to 1945, inclusive. The estimates of the number of units that petitioner could have sold in 1939 with the changes having been made 2 years earlier than they were is supported by the testimony of several of petitioner's witnesses. Although we do not question the sincerity and impartiality of these witnesses, we nevertheless are unable to accept their estimates as a basis for a reconstruction of petitioner's base period earnings. There were adverse factors affecting petitioner's business in 1939, such as depressed economic conditions and restricted oil production, which may have been obscured by the passing of time. We think that the views*45 of these witnesses reflect too much of the optimism born of later more prosperous years. But even if petitioner had been able to obtain orders for as many portable rotary drilling units and telescoping derricks in 1939 as claimed, there is no showing that it had the plant capacity to produce them. Petitioner represented to the Commissioner in its claim for relief under section 721, in connection with its Russian order for drilling rigs, that it was required to double its plant capacity in order to produce the 40 units contracted for early in 1940. Obviously, without a large expansion of its plant petitioner would not have had the capacity to produce 30 rotary drilling rigs and 12 telescoping derricks in 1939. And if petitioner had expanded its plant in the base period to handle the larger volume of business, production costs would likely have been much greater and net profits per unit smaller. *520 The evidence as a whole, we think, falls far short of supporting petitioner's constructive average base period net income figure of $ 248,853.68 for 1940 and $ 298,710.52 for the other excess profits tax years, as against petitioner's actual average base period net loss of over *46 $ 5,000. On the other hand, we think that the constructive average base period net income of $ 8,700, which the respondent has determined, is entirely inadequate to place petitioner's base period operations under the changed conditions on a normal basis. There is nothing in the record to show how respondent arrived at that amount or even what factors he took into account in making his determination. From our careful study of the evidence and our best appraisal of the arguments offered by the parties in their briefs, we have concluded that a fair and just amount representing normal earnings to be used as a constructive average base period net income is $ 30,000. This amount should be properly adjusted for income tax as to the year 1940. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. Represents export sales.↩ 1. Represents export sales.↩ 2. Represents sale of rebuilt unit.↩ 1. This was purchased in the United States for use in Greece.↩ 1. Includes one well servicing unit later converted to a telescoping derrick unit.↩