Fanner Mfg. Co. v. Commissioner

The Fanner Manufacturing Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Fanner Mfg. Co. v. Commissioner Docket No. 37142 United States Tax Court 29 T.C. 587; 1957 U.S. Tax Ct. LEXIS 8; December 30, 1957, Filed *8 Decision will be entered for the respondent. Petitioner, a producer of castings and finished metal products, claims relief from excess profits tax under section 722 (b) (4), I. R. C. 1939. Held, petitioner has shown that it increased its capacity for production during the base period but has failed to establish a resulting increase in the level of its base period net earnings. Frank E. Bubna, Esq., for the petitioner. James F. Shea, Esq., and William O. Allen, Esq., for the respondent. Withey, Judge. WITHEY *587 The respondent denied petitioner's applications for relief and claims for refund of excess profits taxes under section 722 (b) (2), (3), (4), and (5) of the Internal Revenue Code of 1939 for the years 1941 through 1945. The issues presented for our decision are whether the mechanization of petitioner's*9 foundry in 1939 constituted a change in the character *588 of its business by reason of a difference in its capacity for production or operation within the meaning of section 722 (b) (4) of the 1939 Code and, if so, whether it has established a fair and just amount representing normal earnings to be used as a constructive average base period net income. Additional issues presented by the pleadings were abandoned by petitioner at the hearing herein. FINDINGS OF FACT. Some of the facts have been stipulated and are found accordingly. Petitioner is a corporation organized under the laws of the State of Ohio in 1894 with its principal place of business located at Cleveland, Ohio. It filed its corporation income and declared value excess-profits tax returns and excess profits tax returns for 1940, 1941, 1942, 1943, 1944, and 1945 with the collector of internal revenue for the eighteenth district of Ohio at Cleveland, Ohio. Petitioner filed applications for relief under section 722 on Form 991 and claims for refund on Form 843 for the years 1941 to 1945, inclusive, on the dates and in the amounts as follows: Year Form No. Amount of claim [991] $ 91,489.53 [843] 16,585.73 [991] 51,845.17 [843] 3,386.29 [991] $ 51,845.18 [843] 2,913.15 [991] 54,722.82 [991] 54,722.82 *10 The foregoing claims were disallowed in full by the respondent. The petitioner's gross income and deductions, together with its net income and/or net loss for Federal income tax purposes for the years 1936 through 1945 as per its Federal tax returns, were as follows: *589 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive. [1938] Gross income $ 672,669.40 $ 701,668.86 $ 425,432.66 Deductions 356,490.93 425,914.59 345,128.96 Capital gains Net income per return 316,178.47 275,754.27 80,303.70 Adjustment -- Gross Income Renegotiation Capital gains Net gain from sale property Interest on United States savings bonds Recoveries of bad debts Other income Gain on bonds Deductions Depreciation 994.71 1,216.42 (316.94) Federal capital stock tax 66.00 (44.00) Bad debts 6,877.57 Frozen bank a/c recoveries 436.23 Auto expense Legal Normal tax Edgewater Plant expense Canadian discount on taxes Taxes (State franchise) Administration expense Adjustments in Stipulation to Tax Court Edgewater Plant expense Ohio franchise taxes Depreciation Final adjusted net income 317,173.18 284,350.49 79,942.76 *11 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive. [1939] Normal Excess profits Gross income $ 557,574.24 $ 623,729.69 Deductions 389,365.92 422,973.84 Capital gains Net income per return 168,208.32 200,755.85 $ 147,126.24 Adjustment -- Gross Income Renegotiation Capital gains Net gain from sale property Interest on United States savings bonds Recoveries of bad debts Other income Gain on bonds Deductions Depreciation 8,081.54 7,963.67 7,963.67 Federal capital stock tax (73.00) (4,608.00) (4,608.00) Bad debts (1,291.60) Frozen bank a/c recoveries Auto expense 319.00 319.00 Legal 258.00 258.00 Normal tax (943.84) Edgewater Plant expense Canadian discount on taxes Taxes (State franchise) Administration expense Adjustments in Stipulation to Tax Court Edgewater Plant expense Ohio franchise taxes Depreciation Final adjusted net income 176,216.86 204,688.52 148,823.47 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive. [1941] Normal Excess profits Gross income $ 1,154.914.81 Deductions 563,863,49 Capital gains Net income per return 591,051.32 $ 561,585.27 Adjustment -- Gross Income Renegotiation Capital gains Net gain from sale property Interest on United States savings bonds 33.33 Recoveries of bad debts Other income Gain on bonds Deductions Depreciation 12,485.48 12,485.48 Federal capital stock tax 2,105.11 2,105.11 Bad debts Frozen bank a/c recoveries Auto expense Legal Normal tax Edgewater Plant expense 20,468.73 20,468.73 Canadian discount on taxes (135.29) (135.29) Taxes (State franchise) Administration expense Adjustments in Stipulation to Tax Court Edgewater Plant expense (10,369.40) (10,369.40) Ohio franchise taxes (384.90) (384.90) Depreciation (519.67) (519.67) Final adjusted net income 614,734.71 585,235.33 *12 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive [1942] Normal Excess profits Gross Income $ 1,048,822.72 Deductions 484,635.34 Capital gains Net income per return 564,187.38 $ 545,403.58 Adjustment -- Gross Income Renegotiation (178,000.00) (178,000.00) Capital gains 6,470.21 Net gain from sale property (47.00) (47.00) Interest on United States savings bonds 66.67 Recoveries of bad debts (825.89) Other income (6,423.21) (6,423.21) Gain on bonds Deductions Depreciation 8,941.42 8,941.42 Federal capital stock tax (1,250.00) (1,250.00) Bad debts Frozen bank a/c recoveries Auto expense Legal Normal tax Edgewater Plant expense 3,371.80 3,371.80 Canadian discount on taxes (44.92) (44.92) Tax (State franchise) Administration expense Adjustments in Stipulation to Tax Court Edgewater Plant expense Ohio franchise taxes (462.10) (462.10) Depreciation (590.12) (590.12) Final adjusted net income 369,220.13 370,073.56 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive. [1943] Normal Excess profits Gross income $ 1,133,867.34 Deductions 500,963.50 Capital gains Net income per return 632,903.84 615,841.20 Adjustment -- Gross Income Renegotiation (169.654.00) (169,654.00) Capital gains 8,254.46 Net gain from sale property Interest on United States savings bonds 66.67 Recoveries of bad debts Other income (8,254.46) (8,254.46) Gain on bonds Deductions Depreciation 8,560.64 8,560.64 Federal capital stock tax 625.00 625.00 Bad debts Frozen bank a/c recoveries Auto expense Legal Normal tax Edgewater Plant expense 4,660.36 4,660.36 Canadian discount on taxes (94.99) (94.99) Tax (State franchise) Administration expense Adjustments in Stipulation to Tax Court Edgewater Plant expense Ohio franchise taxes (483.10) (483.64) Depreciation (735.46) (735.46) Final adjusted net income 475,848.42 450,464.65 *13 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive. [1944] Normal Excess profits Gross income $ 984,382.61 Deductions 495,273.70 Capital gains Net income per return 489,108.91 $ 456,905.13 Adjustment -- Gross Income Renegotiation (50,000.00) (50,000.00) Capital gains Net gain from sale property Interest on United States savings bonds Recoveries of bad debts Other income Gain on bonds (10,915.96) Deductions Depreciation 7,810.80 7,810.80 Federal capital stock tax Bad debts Frozen bank a/c recoveries Auto expense Legal Normal tax Edgewater Plant expense Canadian discount on taxes Tax (State franchise) 1,747.25 1,747.25 Administration expense Adjustments in Stipulation to Tax Court Edgewater Plant expense Ohio franchise taxes Depreciation Final adjusted net income 448,666.96 405,547.22 Schedule of Gross Income, Deductions and Net Income per Return, Adjustments Made by Respondent and Finally Determined for the Years 1936 to 1945, Inclusive. [1945] JNormal Excess profits Gross income $ 945,345.95 Deductions 469,275.06 Capital gains 25,359.51 Net income per return 501,430.40 $ 442,845.89 Adustment -- Gross Income Renegotiation (50,000.00) (50,000.00) Capital gains 90.00 Net gain from sale property Interest on United States savings bonds Recoveries of bad debts Other income Gain on bonds Deductions Depreciation 2,637.39 2,637.39 Federal capital stock tax 8,125.00 8,125.00 Bad debts Frozen bank a/c recoveries Auto expense Legal Normal tax Edgewater Plant expense Canadian discount on taxes Tax (State franchise) Administration expense (1,440.00) (1,440.00) Adjustments in Stipulation to Tax Court Edgewater Plant expense Ohio franchise taxes Depreciation Final adjusted net income 460,842.79 402,168.28 *14 *591 Petitioner's gross sales, net profits, and/or net loss for 1936 through 1945 as per its books, together with a reconciliation thereof to the foregoing schedule, are as follows: Gross Sales and Net Profit (or Loss) Per Books and Reconciliation to Returns for the Years 1936 to 1945, Inclusive. [1938] Net income per books $ 205,018.65 $ 164,815.09 ($ 47,468.38) Provisions for income and excess profits tax 39,000.00 96,000.00 96,000.00 Provisions for contingencies Net increases to reserves 78,648.65 24,864.00 39,245.65 Group insurance premium adjustment 476.49 39.71 150.97 Canadian taxes Depreciation not on books Recovered bad debts previously disallowed (2,905.76) (9,383.37) (7,657.57) Losses -- bad debts previously disallowed (2,998.55) Recovery of accounts written off Interest paid on income tax deficiency (937.09) (581.16) Interest received on income tax refunds 33.03 Partitions abandoned (123.92) Federal capital stock tax Net income per return 316,178.47 275,754.27 80,303.70 Gross sales per books 1,913,333.77 2,069,598.70 1,252,646.15 Gross receipts -- other 4,690.86 1,961.93 1,859.21 Gross sales per return 1,918,024.63 2,071,560.63 1,254,505.36 *15 Gross Sales and Net Profit (or Loss) Per Books and Reconciliation to Returns for the Years 1936 to 1945, Inclusive. [1941] Net income per books $ 75,308.64 $ 158,627.85 $ 216,155.27 Provisions for income and excess profits tax 96,000.00 48,290.50 374,000.00 Provisions for contingencies Net increases to reserves 16,834.52 15,448.14 14,801.07 Group insurance premium adjustment 392.94 1,089.99 Canadian taxes 719.97 Depreciation not on books (21,610.64) (21,610.64) (14,128.22) Recovered bad debts previously disallowed (422.62) Losses -- bad debts previously disallowed Recovery of accounts written off 1,862.50 Interest paid on income tax deficiency (157.02) (116.11) Interest received on income tax refunds Partitions abandoned Federal capital stock tax (1,470.65) Net income per return 168,208.32 200,755.85 591,051.32 Gross sales per books 1,645.211.87 1,861,395.78 3,097,040.06 Gross receipts -- other Gross sales per return 1,645,211.87 1,861,395.78 3,097,040.06 Gross Sales and Net Profit (or Loss) Per Books and Reconciliation to Returns for the Years 1936 to 1945, Inclusive. [1943] Net income per books $ 119,253.62 $ 140,257.63 Provisions for income and excess profits tax 401,150.00 457,590.00 Provisions for contingencies 28,000.00 Net increases to reserves 57,520.32 23,503.58 Group insurance premium adjustment 127.45 246.50 Canadian taxes 432.00 956.70 Depreciation not on books (14,296.01) (14,527.14) Recovered bad debts previously disallowed (3,123.43) Losses -- bad debts previously disallowed Recovery of accounts written off Interest paid on income tax deficiency Interest received on income tax refunds Partitions abandoned Federal capital stock tax Net income per return 564,187.38 632,903.84 Gross sales per books 2,987,791.80 3,152,888.85 Gross receipts -- other Gross sales per return 2,987,791.80 3,152,888.85 *16 Gross Sales and Net Profit (or Loss) Per Books and Reconciliation to Returns for the Years 1936 to 1945, Inclusive. [1945] Net income per books $ 77,772.42 $ 99,088.98 Provisions for income and excess profits tax 372,600.00 351,500.00 Provisions for contingencies 36,000.00 18,000.00 Net increases to reserves 16,628.39 41,767.18 Group insurance premium adjustment 83.04 297.07 Canadian taxes 858.62 514.95 Depreciation not on books (14,833.56) (9,737.78) Recovered bad debts previously disallowed Losses -- bad debts previously disallowed Recovery of accounts written off Interest paid on income tax deficiency Interest received on income tax refunds Partitions abandoned Federal capital stock tax Net income per return 489,108.91 501,430.40 Gross sales per books 2,935,732.98 2,855,112.91 Gross receipts -- other Gross sales per return 2,935,732.98 2,855,112.91 *592 Since petitioner was in existence during the years 1936 through 1939, it is entitled to use an excess profits credit based on income pursuant to the provisions of section 713 of the 1939 Code. Inasmuch as its excess profits credit computed under the income*17 method results in a lesser excess profits tax liability than if its excess profits credit had been computed under the invested capital method, petitioner's excess profits credits for the years 1940 to 1945, inclusive, were computed under the income method. Its excess profits credits so computed without the application of section 722 of the 1939 Code are as follows: Year Income credit method [1940] $ 153,895.18 [1941] 199,772.37 [1942] 226,381.00 [1943] 226,381.00 [1944] 226,381.00 [1945] 226,381.00 The excess profits credits claimed by petitioner for the years here involved are as follows: Excess profits Year credit claimed [1941] $ 284,990.82 [1942] 284,995.43 [1943] 284,995.43 [1944] 283,983.97 [1945] 283,983.97 Petitioner's excess profits net income for the years 1940 through 1945, computed under the income credit method is as follows: Excess profits Year net income [1940] $ 148,823.47 [1941] 585,235.33 [1942] 370,073.56 [1943] 450,464.65 [1944] 405,547.22 [1945] 402,168.28 Petitioner's excess profits tax liability for each of the years here in issue as determined by the respondent without the application of section 722 of the 1939 Code is as follows: [1941] $ 186,905.61 [1942] 124,028.70 [1943] 194,711.17 [1944] 143,712.30 [1945] 141,434.05 *18 During the years 1936 through 1939, petitioner was engaged in the manufacture and sale of four principal types of products: (a) "Chills" and "chaplets," products which did not require any castings produced in its foundry; (b) awning hardware for use in the erection or fastening of awnings; (c) "nipples" for use primarily in the radiator *593 industry; and (d) stove trimmings for use in the manufacture of stoves. In addition, it produced some bushings and plugs. During the base period years petitioner owned and operated a foundry in which it produced malleable castings for use in the manufacture of its awning hardware, nipples, stove trimmings, and miscellaneous products other than chills and chaplets. It also sold to outsiders some malleable castings produced in its foundry. At least 90 per cent of the foundry's production of malleable castings was used in the manufacture of petitioner's finished products, and 10 per cent or less was sold to outsiders. The property which distinguishes malleable castings from steel, iron, or other castings is their flexibility or workability, or what is known to the industry as the "elongation factor." The quality of malleability is acquired*19 by heat treating or annealing. The monthly production (in pounds) of malleable castings produced by petitioner's foundry for each of the base period years was as follows: [1939] January 447,621 738,231 125,980 319,607 February 416,082 679,474 103,618 298,535 March 541,098 802,474 171,719 271,651 April 530,368 981,820 162,008 220,517 May 467,975 695,641 391,982 268,394 June 493,136 537,857 397,298 287,682 July 506,071 450,774 268,111 206,390 August 602,895 407,736 381,481 349,768 September 683,014 491,877 343,395 346,650 October 749,290 387,335 351,894 488,931 November 654,403 195,383 252,846 447,872 December 736,106 82,189 178,445 309,388 6,828,059 6,450,791 3,128,777 3,815,385 The production of malleable castings in petitioner's foundry involved several operations which may be generally described as consisting of the preparation and storage of raw material, placing or dumping raw material into a melting furnace, the preparation of the molding sand, the preparation of molds, the pouring of the molten metal into the molds, cooling the metal, the cleaning or "spruing" of the castings in order to remove*20 "gates" or "runners," and the inspection, grinding, annealing, and final cleaning of the castings. Some of the foregoing operations, such as the melting and molding, must be integrated, while others, such as cleaning and grinding, may be performed independently. During 1936, 1937, 1938, and a part of 1939, petitioner's melting operation was conducted by what is known as the "batch system." Under this method the "sprue" was brought into the foundry from the yard by means of buckets, broken up, forked into containers, and set alongside the furnace together with pig iron and other raw materials. *594 The raw material then was dumped into the furnace by means of an overhead crane. After several hours of heating, the metal was brought to a point where it was ready for pouring. The molding of malleable iron in petitioner's foundry during 1936, 1937, 1938, and a part of 1939 was conducted by a "side-floor" operation. Under this system the molders made molds in a molding machine from sand piled alongside the machine. After shoveling the sand from the floor into the molding machine and completing the mold, a molder would then carry the mold out on the floor and return to repeat the*21 operation. This would continue for approximately 3 hours, at which time the metal in the furnace would be heated to the point required for pouring. The normal time for pouring was 10:30 in the morning. Approximately 45 minutes were required to pour out all the metal in the furnace. Each molder would go to the furnace for the molten metal and would return to his molds and pour the metal into them. Other employees would remove the castings from the molds by hand, put water back into the sand, and bring in a sand cutter to run over the top of the sand so as to throw it back next to the molding machine. The foregoing operation consumed the entire working morning. The process was repeated in the afternoon. In the latter part of 1938, petitioner's officers agreed upon a plan to mechanize the melting and molding operations in the foundry. This program required the acquisition of new equipment as well as the alteration and rearrangement of existing equipment. In December 1938, petitioner entered into a contract with the National Engineering Company of Chicago, Illinois, for the installation of new sand-preparing, sand-handling, and mold-handling equipment at a price of $ 71,412.52. *22 The installation of this equipment, which included a conveyer system, was begun in January 1939, and was completed during July of that year. The mold-conveyer equipment installed in petitioner's foundry was the second of its kind installed in any foundry in the United States. The mechanized unit furnished by National Engineering Company consisted of 32 molding stations which were provided with overhead sand so that the molder, instead of shoveling the sand off the floor by hand, simply pulled a lever which caused the sand to fall into the mold in front of him. Under this system, the molder's function was to make the mold, set the cores, and place a mold on a continuous conveyer. The mold conveyer would then carry the mold to the pouring station. The molten metal was poured into the mold and the mold then proceeded on the conveyer to a cooling zone. After the metal had become solidified the mold was carried further on the conveyer to a shakeout station where it was dumped into a vibrating screen. The vibrating screen separated the casting from the sand. The casting *595 then proceeded into the cleaning area where the preliminary cleaning was done. The sand fell into a*23 conveyer beneath the floor and was carried by an elevator into a screen in a storage bin of about 150-ton capacity. It was fed out from the storage bin by weight hoppers into two mixers where it was prepared by mixing it with clay and water. Because of the evaporation of the water in the sand due to the heat of the molten metal, the sand cannot be used again without proper conditioning. In order to revive the sand, a mixer or "sand muller" is used. In the muller the necessary amount of clay, water, and other ingredients is added and mixed with the sand. The sand is then fed through a hopper into another conveyer to a distributing conveyer. From the distributing conveyer the sand flows off into 32 hoppers which are located directly over the molding stations. Along with the sand-preparing and mold-handling equipment installed by petitioner, two new conveyers were acquired and installed at a cost of $ 6,978.80. The installation of the foregoing equipment resulted in a saving in sand of approximately 10 per cent. As part of its mechanization program, the petitioner in July 1939, installed what is known as a duplex system for the melting of metal. The purpose of this installation*24 was to provide a continuous flow of molten metal to the conveyer mold-handling system. This phase of the mechanization program involved the purchase of a cupola and skip-hoist charger at a cost of $ 9,370. The existing furnaces were converted into air furnaces, and troughs and runners were installed between the cupola and the air furnaces. The skip hoist acquired was a piece of electrically operated equipment which was used to take the raw materials from the floor to the top of the cupola where they were automatically dumped in the cupola. The raw materials were stockpiled around the scale, weighed, and put into the skip hoist. The procedure for the melting operation of the duplex system was as follows: Employees involved in this operation reported at 9 o'clock in the evening to prepare the cupola, load it with the necessary raw materials, and fire it. After the raw materials were melted, the molten iron flowed through a system of runners or spouts from the cupola to the air furnace. The air furnace is used to refine the metal by reducing the carbon content to the desired consistency and also serves as a holding furnace or storage unit so that when the pourers report for work*25 at 7:30 the following morning, there are approximately 10 tons of molten metal ready for pouring. The melting of additional metal normally continued without interruption throughout the day until the desired quantity was produced. In the fall of 1939, the petitioner acquired an overhead monorail at a cost of $ 4,032.25. The monorail was in the shape of a loop running *596 from the air furnace to the pouring line and was approximately 40 feet in length. The molten metal flowed from a spout in the air furnace into a "bull" ladle which ran on the overhead monorail loop. A bull ladle is a steel shell with one or two spouts lined with refractory metal and has a capacity of about 350 pounds. The molten metal was poured from the bull ladle into the ladles of the independent pourers at the pouring line who then poured it into the molds as they passed along on the mechanized conveyer. The pouring continued throughout the day until all of the molten iron was poured. The maximum capacity for melting under the batch system formerly used by petitioner was 9 tons per heating per furnace. Thus, when two furnaces were operated at two heatings per day, the maximum melting was 36 tons per*26 day. The maximum practical capacity of the duplex system was 50 tons per day. After the installation of the new equipment in 1939, petitioner melted between 45 and 50 tons of metal per day. The number of tons of rough castings produced from the raw material is approximately one-third. Thus, 36 tons of melt would produce 12 tons of rough castings, and 45 to 50 tons of melt would produce between 15 and 17 tons of rough castings. The remaining two-thirds, or sprue, was used in subsequent melting. The annual capacity of petitioner's foundry to produce malleable castings under the batch system was approximately 6,000,000 pounds a year, working 8 hours per day, 5 days per week for 50 weeks. Under the duplex and conveyer system, petitioner's annual capacity was approximately 8,500,000 pounds per year. The raw material utilized in the manufacture of malleable iron consists of the materials used in the cupola itself, such as coke, stone, and sand, and the raw material dumped into the cupola, such as pig iron, steel scrap, sprue, and ferrous alloys. The proportions of raw materials making up the charge in the duplex process are different from the proportions used in the batch system. *27 Under both systems approximately 65 per cent of the raw materials consisted of returns. However, under the batch system the remaining 35 per cent consisted of 3 per cent steel scrap and 32 per cent pig iron, whereas under the duplex system it consisted of 18 per cent steel scrap and 17 per cent pig iron. Although the percentage of pig iron normally required in the duplex melting operation was approximately 15 per cent less than in the batch system, the proportion of pig iron actually used during 1939 after the installation of the duplex system in July of that year increased by about 0.8 per cent. After the completion of the installation of the mechanized equipment in 1939, petitioner experienced operating difficulties due to the need of training personnel to conduct operations with which they had had no prior experience. In addition, beginning in the latter part *597 of 1939, petitioner received numerous complaints from its own manufacturing division and from outside customers that the metal in its castings was inferior and that the castings were breaking. Many such castings were returned to petitioner because they were failing in service. The inferiority in the quality*28 of castings ultimately was discovered to be caused by what is known in the industry as "green metal." The production of green metal was due to the fact that a second hole had been tapped in the duplex furnace for the purpose of serving the molders working on the side floor. The effect of this was that iron was taken directly off the bottom of the cupola before it had been refined in the air furnace. This problem continued during the early months of 1940 until the complaints became so numerous and the number of castings rejected became so large that it was necessary for petitioner to shut down its mechanized system for approximately 2 months. During this period it reverted to batch-type melting and side-floor molding. A solution to petitioner's green metal problem was not found until the summer of 1940 whereupon operations with the duplex system and conveyer were resumed and continued thereafter without interruption. After the castings were removed from the mold they were cleaned mechanically either in tumbling mills or by means of a piece of cleaning equipment known as a Wheeler-Broter Tumblast. After the castings were cleaned they were placed in containers and taken to the inspection*29 department. The castings subsequently were taken to the grinding department where they were ground on stand grinders. After grinding, the castings were moved to the annealing or heat-treating department. Throughout the base period, the petitioner had 8 batch-type, pulverized, coal-fired ovens of 20-ton capacity in its annealing department, which were sufficient to handle 17 tons of rough castings per day. Under the duplex melting process, all of the equipment used by petitioner to process its castings after molding was sufficient to handle 17 tons of castings per day. Under the batch system of melting, 90 to 100 molders were required to handle the daily production of the two furnaces (approximately 36 tons of melt). Since there were only 32 molder stations on the conveyer, any additional molding which petitioner might find necessary had to be conducted on the side floor. The number of molders employed on the side floor after the installation of the conveyer fluctuated from day to day. Normally, an average of approximately 42 molders (10 on the side-floor operation) were required to handle the capacity production of 50 tons which was made possible with the installation of mechanical*30 equipment. However, during the last quarter of 1939, 15 molders worked on the side floor and during 1941, 26 *598 molders were so engaged. In addition, after the installation of the conveyer and duplex systems, petitioner shifted 19 of its molders to nonmolding activities. These 19 employees continued to be classified as molders. Under a normal and efficient operation, the mechanized molding and the duplex melting systems would require four less foundry employees than were previously required. The average number of molds produced by one molder during a day on the side-floor operation ranged from 100 to 120. Since a molder normally made molds 5 to 6 hours per day, this represented an average of 20 to 22 molds per hour. With the mechanical equipment, a molder normally averaged 40 molds per hour. The following tabulation discloses the average number of pounds of castings produced by petitioner for each molder-hour worked during the years 1936, 1937, 1938, and the periods January 1 through June 30, 1939, July 1 to December 31, 1939, and October 1 through December 31, 1939, and the year 1941: Year Average pounds per molder-hour (1) (2) [1936] 45.6 [1937] 42.3 [1938] 45.5 First half -- 1939 38.8 Second half -- 1939 41.2 69.0 Fourth quarter -- 1939 43.1 70.3 [1941] 52.3 95.4 *31 NOTE: Column 1 includes production of all employees classified as molders, whether working on conveyer, side-floor, or nonmolding operations. Column 2 includes production of only those working on the conveyer. Throughout the base period the molders in petitioner's foundry were paid on a piecework basis at a fixed price per 100 molds. After the installation of the mechanical equipment in 1939, petitioner established different piecework prices for molders who worked on the side floor and for those who worked on the conveyer. The total number of hours worked and the average rate per hour earned by the molders in petitioner's foundry for each of the base period years were as follows: [1939] Total hours 158,689 1/2 157,115 1/4 68,593 1/2 94,681 3/4 Average rate earned per hour $ 0.754 $ 0.884 $ 1.048 $ 0.964 Pursuant to petitioner's practice of burning certain types of records 6 years after their preparation, its records showing the actual production and earnings of its molders for 1936, 1937, 1938, and 1939 were destroyed in 1942, 1943, 1944, and 1945, respectively. *599 The net savings in costs to petitioner resulting from *32 the use of the mold-handling conveyer and the duplex operation depend in part upon the number of breakdowns experienced and the cost of repairs and maintenance. Additional expenses resulting from the installation of the conveyer and duplex systems include the cost of limestone, coke, light and power, refractories, a metallurgical laboratory, melting steel, ferro-alloys, and depreciation expense. The mechanization of petitioner's foundry in 1939 by the installation of the duplex melting system, together with the conveyer and sand-handling and mold-handling equipment, constituted an increase in its capacity for operation and production within the meaning of section 722 (b) (4) of the 1939 Code. The foregoing change in petitioner's capacity for operation and production is not shown to have resulted in an increased level of base period earnings. Petitioner's excess profits taxes for 1941, 1942, 1943, 1944, and 1945, computed without the benefit of section 722, are not excessive and discriminatory and its average base period net income is an adequate standard of its normal earnings. OPINION. Petitioner contends that it is entitled to excess profits tax relief under section 722 (b) (4)*33 of the 1939 Code 1 because the mechanization of its foundry in 1939 constituted a change in the character of its business by reason of a difference in the capacity for *600 production or operation and did not reach by the end of the base period the level of earnings it would have reached had the qualifying change occurred 2 years earlier. The respondent has taken the position that the installation by petitioner of the duplex melting system, together with the sand-handling and mold-handling equipment and conveyer, in 1939, was a routine technological improvement which could not be considered as effecting a change in the character of the business under section 722 (b) (4). Respondent further contends that the foregoing installations were not productive of a higher level of earnings. *34 Although petitioner has demonstrated to our satisfaction that it increased its capacity for the production of castings during the base period, careful consideration of the oral testimony and documentary evidence here presented has convinced us that it has failed to demonstrate that, assuming an increase in capacity for production and operation, such increase either did or, if occurring 2 years earlier, would have resulted in an increased level of base period net income. Wisconsin Farmer Co., 14 T. C. 1021; Green Spring Dairy, Inc., 18 T. C. 217. Manifestly, such an increase in earning capacity may result either from increased sales or from a decrease in operating expenses. Nielsen Lithographing Co., 19 T. C. 605. Petitioner's income was realized primarily from the sale of a variety of finished products of which the castings produced by its foundry were only a part. Approximately 90 per cent of the castings produced by petitioner's foundry were used in the manufacture of its finished products. However, except for its gross sales and net income for the base period years, petitioner has not*35 presented sales data with respect to its finished products, nor is there a markedly upward trend of sales indicated thereby. We have no evidence before us tending to show the existence of a market for its products, nor disclosing its ability to capture a share of the market. With respect to the portion of its rough castings sold to outside customers (approximately 10 per cent), petitioner's sales manager testified that in his opinion if the mechanization of its foundry had occurred 2 years earlier, it would have been able to "push" the sale of its products with a competitive price due to an estimated decrease in the cost of production. Again, however, we are without proof as to the existence of an "outside" market, or as to petitioner's ability to capture a portion of the market. The evidence before us bearing on the extent of the reduction, if any, in the cost of production resulting from its mechanization program is incomplete and not sufficiently reliable to enable us to compare the cost of production before and after mechanization. Although cost savings on certain items may have been realized by petitioner after *601 mechanization, the record discloses that the net savings*36 in costs to petitioner resulting from the use of the mold-handling conveyer and the duplex operation depend in part upon the number of breakdowns experienced and the cost of repairs and maintenance. No evidence as to the frequency of breakdowns of petitioner's equipment, or as to the cost of repairs and maintenance, appears on the record before us. Further, it was established on the record that additional expenses resulting from the installation of the conveyor and duplex systems include the cost of limestone, coke, light and power, refractories, installation and maintenance of a metallurgical laboratory, melting steel, ferro-alloys, and depreciation expense. However, no evidence bearing on the extent of the increase in cost of any of the foregoing items was presented for our consideration. We consequently are unable to determine that petitioner actually realized a net saving in the cost of production as a result of its mechanization program in 1939. We are unable to find that, assuming the mechanization of its foundry had occurred 2 years earlier, petitioner would have reached a higher earning level by the end of the base period than it actually reached. Accordingly, petitioner*37 has failed to sustain its burden of proof in that an increased base period net income is not shown to have resulted from the increase in productive capacity which it acquired by the mechanization of its foundry. Reviewed by the Special Division. Decision will be entered for the respondent. Footnotes 1. 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. * * *↩