A. B. Farquhar Co. v. Commissioner

A. B. Farquhar Company, Petitioner, v. Commissioner of Internal Revenue, Respondent A. B. Farquhar Co. v. Commissioner Docket No. 37695 United States Tax Court 28 T.C. 748; 1957 U.S. Tax Ct. LEXIS 149; June 27, 1957, Filed *149 Decision will be entered under Rule 50. Relief under section 722 (b) (4), 1939 Code, denied where changes in the design of certain products were merely routine changes in products already manufactured, and not a substantial departure from the character of the business. John F. Greaney, Esq., for the petitioner. William T. Holloran, Esq., for the respondent. Rice, Judge. RICE *748 This proceeding involves claims for refund of excess profits taxes under section 722 of the Internal Revenue Code of 1939 for the taxable years 1940, 1941, and 1942, in the amounts of $ 9,440.88, $ 93,359.09, and $ 172,574.31, respectively. In his notices of disallowances, respondent allowed in part and disallowed in part petitioner's claims for relief under section 722, and determined further that petitioner was entitled to a constructive*150 average base period net income of $ 75,000 for 1940 and $ 92,000 for each of the years 1941 and 1942. By amended answer, respondent now alleges error with respect to his determination that petitioner qualified for any relief under section 722. He further alleges that petitioner is not entitled to the above-mentioned constructive average base period net income for the years 1940, 1941, and 1942, but, rather, must compute its excess profits credits under the invested capital method for those years. Petitioner's claims for relief were filed under section 722 (b) (4) and (b) (5). At the trial, petitioner abandoned its claim under 722 (b) (5). Some of the facts were stipulated. FINDINGS OF FACT. The stipulated facts are so found and are incorporated herein by this reference. The A. B. Farquhar Company (hereinafter referred to as the petitioner) was organized in 1856 to engage in the manufacture and sale of steam engines, sawmills, agricultural implements, and other machinery. From 1889 until 1944, it conducted its business as a limited partnership association under the laws of the Commonwealth of Pennsylvania. 1 From January 1, 1944, it operated as a corporation. *151 Petitioner filed its income and excess profits tax returns for the calendar years 1940, 1941, and 1942 with the former collector of internal revenue at Philadelphia, Pennsylvania. *749 Prior to 1920, petitioner's business, exclusive of its participation in World War I, during which it manufactured (among other products) hydraulic powder presses for the Hercules Powder Company, was based principally on the manufacture and sale of steam engines and boilers. During the 1920's, after the advent of the internal combustion engine, petitioner looked for other products to manufacture. In 1923, it entered into a contract with the Fred H. Bateman Company (hereinafter referred to as Bateman), the owner of a line of agricultural implements marketed under the trade name of "Iron Age," whereby petitioner agreed to manufacture for Bateman certain of its Iron Age products. On July 1, 1930, petitioner purchased Bateman's farm equipment business, including the exclusive right to manufacture and sell under the Iron Age trade name, "Sprayers -- traction and power, Potato Diggers, Transplanters, Fertilizer Distributors * * *." William J. Fisher (hereinafter referred to as Fisher) began his career*152 with the petitioner in 1902. In 1908, he became foreman of the petitioner's forge shop. Subsequently, he became petitioner's general foreman, general superintendent, a vice president, and, in May 1932, general manager of the business. Utilizing his experience in production and sales, he inaugurated a long-range program designed to rehabilitate petitioner's business. In connection with that program, he undertook an analysis of current production, recommending the elimination of certain products and the addition of others. At various times prior to and during the base period, petitioner discontinued the sale of certain farm implements, but brought out improved models of other farm equipment from time to time. Immediately prior to and during the base period, the trend in the agricultural implement field was directed towards a reduction of the farmer's costs through the manufacture and sale of more efficient and less expensive equipment. To meet that trend, petitioner hired W. W. Tranter (hereinafter referred to as Tranter) in the summer of 1934, to aid in the development of its farm equipment products. Tranter was a graduate engineer whose primary experience was in the "sprayer*153 line." As a result of its efforts, petitioner made improvements in certain of its agricultural products. During the base period, it introduced improved models of its sprayer, duster, potato digger, transplanter, and hay baler. Set forth below are resumes of petitioner's production experience with each of these products, as well as the changes made in their design. Also set forth is a resume of petitioner's experience in the hydraulic press field. Sprayers. Prior to 1930, and continuing through the years in issue, petitioner manufactured and sold commercial spraying machines. Prior to the base period, the machines manufactured by petitioner *750 were capable of developing pressures of 150 to 300 pounds. One unit had been developed which delivered a pressure of 450 pounds. As a result of experimental work, it was discovered that greater pest control could be achieved through the use of greater pressures in the spraying machines. Tranter, therefore, undertook the development of a sprayer for petitioner capable of meeting the demand for greater pressures. As a result, an enclosed-type pump capable of delivering pressures from 600 to 1,000 pounds per square inch was produced. *154 The development of the pump and sprayer was begun in 1936, and the product itself was introduced by petitioner in 1938. Dusters. Commencing in 1932, and continuing through the years in issue, petitioner manufactured and sold crop dusters of one type or another. In 1932, it manufactured and sold a "cavern"-type crop duster, which was a machine equipped with curtains dropping from a platform on the sides and back of the machine, forming an enclosed area into which the dust was blown as the machine passed over the plants. Difficulties were encountered in the operation of that machine due to its weight, a tendency of the powder to concentrate on one side or the other of the machine, and the unequal distribution of air and dust to the duster tubes, which caused the dust to clog in the tubes. As the result of work conducted by Tranter, petitioner developed an adjustable airfoil distributor which eliminated all possibility of the clogging of dust and permitted even distribution. Larger containers were mounted on the machine, increasing capacity. In addition, a lighter weight carriage was devised, the cavern area eliminated, and provision made for a higher blast pressure. Models*155 incorporating these innovations were first produced by petitioner sometime in 1937. Potato diggers. Since 1895, and continuing through the years in issue, petitioner manufactured an elevator-type potato digger. At some point prior to the base period, a trend away from elevator potato diggers of 1-row capacity and toward diggers of 2-row capacity began to develop. To meet that trend, petitioner developed its Kid-Glove potato digger. A major difference between this machine and other diggers then being produced by petitioner was the use of an oil-treated soft wood strap on each of the elevator crossbars. The use of this strap greatly decreased bruising of the potatoes as they were dug from the earth. Isolated sales of the Kid-Glove digger having 1-row capacity were recorded in 1935. In the last quarter of 1936, petitioner first recorded sales of a 2-row model of this machine. Transplanters. Throughout the years 1930 through 1939, petitioner manufactured transplanters of one kind or another. In 1932, it developed an attachment for its potato planter which enabled the farmer to fertilize the ground at the same time the potatoes were planted. Due to the success accorded*156 that apparatus, petitioner considered extending *751 its use in the planting of other crops. As a result of its efforts, it developed the Do-Mor transplanter, which incorporated the automatic fertilizer placement feature. The first sales of this product were made in 1938. Through the use of the Do-Mor transplanter, the farmer was able to regulate the placing of the plant and the use of fertilizer, thereby cutting costs. In addition to the Do-Mor model, petitioner's standard model transplanter could also be equipped with the fertilizer placement attachment at the option of the purchaser. Hay balers. Prior to 1937, petitioner had manufactured a hay-baling press which it referred to as a geyser hay baler. In baling hay with that implement it was necessary for the farmer to gather his hay in the field, carry it to the baler, then fork it into the baler. During the base period, petitioner developed a pickup hay baler. This machine was designed to go into the field, where it was pulled along the windrows picking up the hay which was then passed back into the baler for baling. The bale was then dropped in the field. The first sales of this product were made in 1938. *157 Hydraulic presses. During World War I, petitioner manufactured hydraulic powder presses for the Hercules Powder Company. Thereafter, and continuing through the years in issue, it manufactured and sold various types of hydraulic presses for use in the fruit, furniture, fiber, and powder industries. During the early 1930's, the market demand for hydraulic presses contracted to approximately 5 per cent of its normal volume. As a result of that slump, petitioner sharply curtailed its operations in that field, continuing, however, to manufacture and sell hydraulic presses on a small scale. Throughout that period of depression, petitioner, through the efforts of Fisher, was kept informed of the activity of the hydraulic press market. In the early summer of 1936, that market evidenced a sudden upswing of activity. As a result thereof, petitioner decided to step up its hydraulic press operations and to establish a hydraulic press department. It also decided to manufacture metal-forming hydraulic presses. Prior to that time, petitioner had had no experience in the production of metal-forming presses. In December 1936, an engineer named Gregory was employed to head petitioner's*158 hydraulic press department. He was reputed to be one of the five best hydraulic engineers in the country at that time. In addition, he possessed experience in the manufacture of metal-forming presses. With his arrival, petitioner began to advertise hydraulic presses, metal forming and others, under his design. A major obstacle to the introduction of the metal-forming press was petitioner's lack of completed units to show potential customers. However, as time progressed and more metal-forming presses were completed and sold, that problem was overcome. *752 In 1938, the United States Government started a program for the rehabilitation of its arsenals. On September 1, 1938, petitioner contracted with the War Department to manufacture 144 hydraulic presses for the production of smokeless gunpowder for the sum of $ 505,584. These presses were manufactured subsequent to November 30, 1938. One of the factors that assisted petitioner in obtaining that contract was its reputation in the hydraulic press field. Petitioner's sales of hydraulic presses to the Federal Government and its total sales of hydraulic presses for the years 1938 and 1939 were as follows: Year Government sales Total sales [1938] $ 39,354 $ 69,213.79 [1939] 517,945 572,762.56 *159 In 1940, petitioner's net sales of hydraulic presses totaled $ 629,657. Of this amount, at least $ 465,984 represented sales of powder presses. The following schedule reflects petitioner's sales and net profit (or loss) for the years for the products indicated. 2 Dusters Sprayers Diggers Year Sales P/L Sales P/L Sales P/L [1936] $ 8,034 ($ 977) $ 35,515 $ 2,403 $ 35,173 ($ 2,020) [1937] 21,860 (2,429) 39,492 (343) 34,032 (5,336) [1938] 44,902 (3,491) 65,762 (9,039) 24,509 (11,070) [1939] 51,971 1,915 144,689 (5,931) 21,803 1,090 [1940] 43,041 1,185 97,297 (5,761) 24,173 1,863 [1941] 46,591 3,776 109,813 (11,800) 27,707 [797] Transplanters Balers Hydraulic presses Year Sales P/L Sales P/L Sales P/L [1936] $ 9,934 $ 1,064 $ 36,780 $ 800 [1937] 19,450 (1,285) 1 ($ 1,612) 72,902 (9,155) [1938] 14,458 (1,690) $ 59,197 (8,306) 69,214 (10,429) [1939] 18,865 (4,793) 28,152 (4,546) 572,763 66,827 [1940] 13,062 (2,725) 49,973 (4,925) 629,657 109,765 [1941] 27,629 (4,760) 4,397 (2,591) 1,064,442 108,393 *160 Petitioner's excess profits net income (or loss) for each of the base period years on all products sold by it was: Excess profits net Year income (or loss) [1936] $ 74,413.10 [1937] 78,740.03 [1938] (96,183.98) [1939] 72,053.88 Arithmetic average 32,255.76 *753 Petitioner's excess profits credit based on invested capital for each of the years in issue was: Invested capital Year credit [1940] $ 83,984.36 [1941] 86,703.60 [1942] 91,460.63 Petitioner's average base period net income, computed under section 713 (e), was $ 70,377.19. In his statutory notice of partial disallowance of petitioner's claims for relief, respondent determined petitioner was entitled to a constructive average base period net income of $ 75,000 for 1940 and $ 92,000 for each of the years 1941 and 1942. In arriving at that determination he made the following reconstruction of petitioner's sales for the year 1939: Reconstructed net Product sales -- 1939 Hydraulic presses $ 700,000 Dusters 57,000 Sprayers 250,000 Pickup hay balers 50,000 Kid-Glove potato diggers 24,000 Do-Mor transplanters 19,000 Total 1939 reconstructed "new" product net sales 1,100,000 Total 1939 "old" product net sales 1,406,000 Total 1939 reconstructed net sales 2,506,000 *161 By amended answer, respondent affirmatively alleged petitioner did not change the character of its business within the meaning of section 722 (b) (4) of the Code. He further alleged petitioner was not entitled to the above-mentioned constructive average base period net income for the years 1940, 1941, and 1942, but rather must compute its excess profits credits under the invested capital method for those years. The general business index for the United States applicable to the petitioner for the base period years was 91.2 per cent, 1939 equaling 100 per cent. Petitioner did not change the character of its business either during or immediately prior to the base period. Its average base period net income reflected its normal operations for its entire base period, and is not an inadequate standard of normal earnings. Its excess profits taxes for the years here in issue, computed without benefit of section 722, are not excessive and discriminatory. *754 OPINION. In support of its claims for excess profits tax relief under section 722 (b) (4), 3 petitioner alleges it effected a change in the character of its business during the base period by the introduction of new products. *162 Because of that change, it contends its average base period net income does not reflect normal operations of the business for the entire base period. It argues that its development and sale of the agricultural implements enumerated in our findings, its establishment of a hydraulic press department, and its entry into the metal-working press field served to constitute a difference in products furnished. It further contends that had these products been introduced 2 years earlier, its sales volume by the end of 1939 would have reached at least $ 3,000,000. It concludes that respondent erroneously determined it was entitled to only partial relief under 722 (b) (4), when, in fact, upon proper application of the 2-year push-back rule, its constructive average base period net income for the years 1940, 1941, and 1942, with adjustments for 1940, would have been at least $ 200,000. *163 Respondent's position is that, in view of petitioner's history as a manufacturer of farm equipment, the improvements made to its general line of agricultural products did not constitute a difference in products furnished; and that the changes constituted only routine engineering changes in products already manufactured, and did not constitute a substantial departure from the character of the business then being carried on. Pelton & Crane Co., 20 T. C. 967 (1953); Avey Drilling Machine Co., 16 T. C. 1281 (1951); Stonhard Co., 13 T. C. 790 (1949). He further submits the manufacture and sale by petitioner of *755 hydraulic presses of various types throughout the period 1917 to 1942 rebuts the contention that they were new products within the contemplation of the statute; and that, in any event, petitioner's attempt to distinguish the presses manufactured during the base period years from those previously manufactured on the ground that the former were metal-working presses is without merit, since the record contains no evidence as to the number of metal-working presses produced or the amounts*164 realized upon their sale. He therefore contends that petitioner did not change the character of its business immediately prior to or during the base period by furnishing new or different products; that its average base period net income is not an inadequate standard of normal earnings; and that it is not entitled to any relief under section 722 (b) (4) of the Code. He concedes, as to these affirmative issues, that he bears the burden of proof. We are of the opinion he has carried that burden. Since World War I, petitioner consistently manufactured hydraulic presses of one type or another for various industries. In view of that fact, the mere establishment of a hydraulic press department does not constitute a qualifying change in the character of its business. Its curtailment of hydraulic press production during the depressed period of the early 1930's and reentry into that market when it evidenced an upswing, also fails to qualify it for the relief sought. A. B. Frank Co., 19 T. C. 174 (1952), affd. 211 F. 2d 497 (C. A. 5, 1954). More persuasive is its contention that the introduction of metal-forming presses meets the*165 new product requirement of section 722 (b) (4). However, it is well established that a change in the character of a taxpayer's business must be substantial, and a causal connection must exist between the qualifying factors and an increased level of earnings. Union Parts Mfg. Co., 24 T. C. 775 (1955). Here, even if we assume a substantial change occurred, the facts of this record indicate that petitioner's increased activity in the hydraulic press field and the increased income therefrom stemmed from its contracts with the Federal Government and its production of powder presses, rather than from the production and sale of metal-forming presses. It, therefore, follows that neither the establishment by petitioner of its hydraulic press department, nor its entry into the metal-forming press field, are factors which entitle it to relief under section 722 (b) (4). We also think the evidence justifies a conclusion that petitioner did not change the character of its business by reason of the development and sale of "new" agricultural implements. What we said in Avey Drilling Machine Co., supra, has equal application here. *166 In that case, in holding the development and sale of a high speed drill by the manufacturer of precision drills did not constitute a difference in products furnished, we said, at page 1298: *756 The changes, we think, cannot be characterized as more than improvements. Avey was in the business of building precision drilling machines used to drill small holes in metal. The new machines served the same purpose as the old and, generally, were sold to customers in the same industries as before. A change in character, within the intent of the statute, must be a substantial departure from the preexisting nature of the business. Here, petitioner was in the business of manufacturing agricultural tools; more specifically, dusters, sprayers, potato diggers, transplanters, and hay balers. The "new" products, while constituting more efficient pieces of equipment, in fact served the same purposes as the old, and clearly reached the same markets. We are of the opinion that the changes made were, as respondent contends, only improvements in existing products. Moreover, the "new" products fitted into the general line of products being sold by the petitioner. They were not a "substantial*167 departure from the preexisting nature of the business" in which petitioner was then engaged. We, therefore, conclude that petitioner did not change the character of its business within the meaning of section 722 (b) (4) by reason of its development and sale of the designated "new" agricultural products. Pelton & Crane Co., supra; Avey Drilling Machine Co., supra; and Stonhard Co., supra. Since petitioner did not change the character of its business immediately prior to or during the base period, and its average base period net income is not an inadequate standard of normal earnings for that period, its excess profits taxes, as computed without benefit of section 722, are not excessive and discriminatory. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. Such an association is taxable as a corporation. Regs. 103, sec. 19.3797-6; and Regs. 111, sec. 29.3797-6.↩ 2. No attempt to segregate the sales of "old" and "new" products has been made, since no basis for allocation appears in the record.↩ 1. Experimental cost of sales of $ 1,494.81 plus selling expense of $ 117.10.↩ 3. SEC. 722. GENERAL RELIEF -- 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 -- * * * * (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 purpose 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 * * *↩