Fezandie & Sperrle v. Comm'r

Fezandie & Sperrle, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Fezandie & Sperrle v. Comm'r Docket Nos. 112521, 1118 United States Tax Court 5 T.C. 1185; 1945 U.S. Tax Ct. LEXIS 27; December 10, 1945, Promulgated *27 Decision will be entered under Rule 50. Change in character of business which could not have been made but for the occurrence of the European War, held not to entitle petitioner to relief under section 722. Richard W. Wilson, Esq., and Franklin C. Ellis, C. P. A., for the petitioner. Z. N. Diamond, Esq., J. D. Bierman, Esq., and Sidney B. Gambill, Esq., for the respondent. Opper, Judge. OPPER *1185 These proceedings involve the correctness of the determinations of the respondent which disallowed petitioner's applications for relief for the calendar years 1940 and 1941, filed under section 722 (b) (4) *1186 of the Internal Revenue Code. The two proceedings, raising substantially the same questions for each year, were consolidated at the hearing. In Docket No. 112521 petitioner seeks relief for the*28 calendar year 1940 in the amount of $ 1,923.17. In Docket No. 1118 it seeks relief for the calendar year 1941 in the amount of $ 4,871.07 on the basis of an amended application, the original claim for 1941 being in the amount of $ 2,946.86. The parties agree that the petitioner is entitled to some refund of 1941 excess profits tax (1) on account of a net operating loss carry-back from 1942 to 1941, and (2) on account of an unused excess profits carry-back from 1943 to 1941. These circumstances do not alter the basic issues; the only question raised thereby is the amount of the refund, to be determined on the basis of the ultimate decision in this case. The question is whether petitioner has shown itself entitled to relief under section 722 of the code. To answer that question the following issues are raised. 1. Has petitioner shown that during the base period it changed the character of its business and that as a result thereof the average actual base period net income does not reflect the theoretical normal operation for the entire base period of the changed business? 2. If so, what would be a fair and just amount representing theoretical normal earnings to be used as constructive*29 average base period net income? FINDINGS OF FACT. Petitioner is a corporation organized under the laws of the State of New York, with its principal office and place of business at 205 Fulton Street, New York, New York. It filed its excess profits tax returns for the periods here involved with the collector of internal revenue for the second district of New York. Petitioner was incorporated in 1925 to take over the business theretofore operated as a partnership by Fezandie and Oscar E. Sperrle. The corporation was formed after Fezandie's death, with Sperrle as sole stockholder and president during its entire existence. Petitioner's office has been located, during its entire existence, in a 4-story building (25 ft. by 100 ft.) which it owns. The building serves as both office and warehouse. Other warehouse space is rented from time to time as needed. Petitioner's inventories generally averaged about $ 40,000, which filled its available storage space. Since its organization petitioner has been a jobber and dealer in dyestuffs and coal tar colors used for various manufacturing purposes, such as paper, wool, and metals. Its business prior to December 1939 *1187 was substantially*30 confined to the domestic trade, with a very small export business, none of which was actively solicited. Petitioner's sole advertising was through trade papers, there being no advertising directly for the foreign market. Its occasional export orders were obtained through individuals who while traveling abroad might contact some user of petitioner's products and arrange a sale. Such sales were less than 5 per cent of petitioner's business. It filled all export orders it obtained. Prior to December 1939 petitioner obtained its materials upon the open market from different sources. Approximately 10 percent of its purchases were from General Dyestuff Corporation, of which Ernest K. Halbach was president. On July 31, 1925, a group of German dye manufacturing corporations (which later became I. G. Farbenindustrie Aktiengesellschaft, hereinafter referred to as I. G. Farben) entered into an agreement with Grasselli Dyestuff Corporation, a Delaware corporation (hereinafter referred to as Grasselli). Under the terms of this agreement the predecessors of I. G. Farben placed at the disposal of Grasselli certain patents, processes, and formulae and the like, and Grasselli was granted during*31 the life of the agreement the sole and exclusive right to manufacture colors and dyes thereunder in continental United States, Puerto Rico, Virgin Islands, Philippine Islands, Hawaiian Islands, Alaska, Guam, and Canada. The agreement was binding on successors and assigns; and in case of merger or consolidation of parties thereto, the merged or reorganized corporation was to perform all the covenants remaining to be performed. Under paragraph 8 of the aforesaid agreement it was provided in part as follows: Dyestuff [Grasselli] agrees to confine its manufacture and sale of said products to the United States of America, its territories and Canada. Inasmuch, however, as in the future development of the dyestuff industry the United States of America may become an important producing center, it seems unwise for Dyestuff to bind itself for all time to refrain from offering its products in countries other than the United States of America, its territories and Canada for the reason that other United States companies not so restricted would have the advantage of foreign markets, therefore, it is agreed between Dyestuff and Hoeschst and the Manufacturers [predecessor of I. G. Farben] that, *32 when the time arrives that manufacturing dyestuffs has so far advanced in the United States of America as to make export business attractive and enjoyed by other manufacturers in the United States of America, there shall be a joint conference between Dyestuff and Hoeschst and the Manufacturers, and this subject shall be given careful consideration, and if conclusively proved to the satisfaction of Dyestuff and Hoeschst and the Manufacturers to be of advantage to all of them, then Hoeschst and the Manufacturers shall waive this restriction, and Dyestuff shall be authorized to sell and export to other countries than the United States of America, its territories and Canada. * * * *1188 Grasselli changed its name in 1927 to General Aniline Works, Inc. General Aniline & Film Corporation was organized in 1929 and acquired General Aniline Works, which now is the dyestuffs division of General Aniline & Film Corporation. General Dyestuff Corporation is the sole selling agent for General Aniline dye and color products, under the terms of an agreement of 1927 which provided in part as follows: Dyestuff [Grasselli], subject to existing agreements, expressly covenants and agrees that it will*33 not sell, consign or deliver directly or indirectly to any individual, firm or corporation doing business in the United States of America, other than General, any of its manufactured products during the continuance of this agreement. On September 19, 1939, I. G. Farben cabled General Aniline as follows: For Genanilin with reference to article eight of our agreement dated July 31, 1925 in addition to Canada we release you from export restriction in regard to following countries Great Britain British India Australia New Zealand but only for duration of present state of war and as far as supplies to following firms are concerned IG Dyestuffs Limited 14 Bridge Street Manchester 3 Chem Dyes Ltd Wippet Road Ballard Estate Bombay Dychem Trading Co Pty Ltd 573 Lonsdale Street Melbourne Cone Dyes and Chemicals Ltd 15 Courtenay Place Wellington C Three please confirm Later on the same date, I. G. Farben cabled as follows: Referring to our telegram of the 19th of this month hold in abeyance until you hear from us On September 21, 1939, I. G. Farben then cabled as follows: Our two telegrams of September 19th replace in first telegram "for duration of present state of war" by "until further*34 notice" and act accordingly By later cables export restrictions were lifted for other areas, particularly in Latin America. In November 1939, in an exchange of memoranda between General Aniline and General Dyestuff, it was agreed that General Dyestuff would handle all export business of General Aniline on a basis of a 20 percent commission of Aniline's contract prices. Prior to the fall of 1939 General Dyestuff did not export colors, dyes, or materials used in their manufacture (called intermediates in the trade) outside of the United States, except in a very few isolated cases, involving small amounts of products. After the commencement of the European War German supply was cut off and General Dyestuff was flooded with inquiries for export of dyestuffs. Just prior to December 1939 Halbach, president of General Dyestuff, approached petitioner, explaining the opening of the export market and of Dyestuff's reluctance to enter the export sales field because of its possible repercussions on Dyestuff's ability to obtain *1189 intermediates from its competitors if it did so, and seeking petitioner as a selling agent. As a result of these negotiations petitioner undertook to sell *35 Aniline's products in the export market, receiving the usual commission of 10 percent; this was later lowered to 5 percent when business increased. The agreement between petitioner and Dyestuff was informal and oral and was considered by the parties thereto to be temporary in nature. This was the first time petitioner had been approached with reference to engaging in the export business. The first export sales under this arrangement were made in December 1939. Petitioner's total sales, domestic and export, from 1940 to 1943, inclusive, were as follows: [1940] $ 1,908,831.24 [1941] 2,069,119.78 [1942] 145,289.24 [1943] 93,022.06 The sales for 1942 and 1943 represented virtually only domestic sales, as the war had curtailed the availability of dyestuffs and the export market had contracted. Petitioner's sales made in the course of its usual business (including its unsolicited foreign sales) from 1936 to 1939, inclusive, were as follows: [1936] $ 96,066.29 [1937] 108,599.81 [1938] 81,045.90 [1939] 103,716.45 Petitioner's new export sales for 1939, represented by the sales of December 1939, the only month of the year in which it engaged in any considerable export business, *36 amounted to almost $ 200,000. Petitioner's excess profits net income for the years 1936 to 1939, inclusive, for the purposes of computing petitioner's excess profits credit for 1940 and for 1941, was as follows: [1936] $ 727.26 [1937] 1,276.87 [1938] 2,673.91 [1939] 8,833.48 Petitioner's excess profits credits based on invested capital, without regard to relief under section 722 and without regard to unused credit or carry-backs, and independent of the specific exemption of $ 5,000, were as follows: [1940] $ 10,411.99 [1941] 10,399.54 [1942] 11,257.38 [1943] 10,885.95 *1190 Petitioner's normal tax net income for the years 1936 to 1943, inclusive, was as follows: [1936] $ 727.26 [1937] 1,276.87 [1938] 2,673.91 [1939] $ 8,833.48 [1940] 57,866.90 [1941] 56,430.00 The 1941 figure is computed thus: $ 72,387.95 (net income), less deduction of $ 3,810.14, representing an operating loss carry-back from the year 1942, and less $ 12,147.81, representing excess profits tax. 1942 (loss of $ 3,810.14) None [1943] $ 205.53 Petitioner's excess profits net income without regard to relief under section 722, for 1940 is $ 57,866.90; for 1941, $ 72,387.95, less 1942 carry-back*37 in the amount of $ 3,810.14, or $ 68,577.81. Petitioner's excess profits tax return filed for the calendar year 1940 reported an excess profits tax liability in the amount of $ 7,811.96; its application for relief sought refund in the amount of $ 1,923.17. Petitioner's excess profits tax return filed for the calendar year 1941 reported an excess profits tax liability in the amount of $ 21,733.68, its application for relief sought refund in the amount of $ 2,946.86, its amended application, in the amount of $ 4,871.07. In the beginning the export business was handled from petitioner's own offices on Fulton Street. Later as business increased an office was established in the General Dyestuff Building. Dyestuff provided one Neisser to assist petitioner in this phase of the business. A service charge was made by Dyestuff for these services in 1940; early in 1941 petitioner began to pay Neisser's salary directly. Dyestuff paid Neisser's salary in 1939, no charge being made for this. A separate account was created on the books of petitioner to reflect the purchases and sales of the export business, which account was designated "Department E." Sperrle, as president of petitioner, received*38 compensation as follows: [1936] $ 10,000 [1937] 10,000 [1938] 5,000 [1939] 12,000 [1940] $ 24,000 [1941] 24,000 [1942] 12,000 [1943] 12,000 One-half of the compensation paid to Sperrle in 1939 was allocated on the books of the petitioner to domestic business, the other half to export business. The books of petitioner, and particularly the records as to "Department E," do not reflect that during December 1939 petitioner charged against the export business on any basis whatsoever such items as depreciation, taxes, rental, and certain other general overhead items. *1191 The total amounts of world exports of coal tar colors and dyes from the United States during the years 1936 to 1939, inclusive, were as follows: [1936] $ 6,080,505 [1937] 6,251,338 [1938] 3,825,205 [1939] 6,432,358 Total exports from the United States in December 1939 of such products were $ 1,160,028. Petitioner's exports during that month were $ 196,286.52. Petitioner duly filed its Federal income and excess profits tax returns for the years 1940 and 1941, and thereafter it filed in due time applications for relief under section 722 for the years 1940 and 1941. The original applications were denied by the*39 respondent; the petitioner's amended application for relief for the year 1941 has not been disallowed by respondent. OPINION. Dealing with the reconstructed base period of section 722 for excess profits tax purposes brings to mind Mr. Churchill's reference, in a different context, to a "riddle inside a mystery wrapped in an enigma." Procedure under that section seems to call for founding hypothesis on assumption based on supposition. The present question reduces to how far we may properly go in presupposing the existence of admittedly imaginary circumstances. The change in its business upon which petitioner premises its application actually took place at the very close of the base period. At that time, the American member of the notorious chemical cartel made an arrangement with petitioner by which it was in effect constituted the foreign selling agent for the color and dye products produced under the cartel patents. This arrangement became possible because of the release of the cartel member and of the foreign territory from restrictions effective until the outbreak of the European War. The increase in business caused by the new arrangement is reflected for only one of the forty-eight*40 base period months. To that extent of course, petitioner has the benefit of increased profits without resort to section 722. For purposes of comparison with its income during excess profits tax years, however, and in order thereby to reduce the amount which would otherwise constitute statutory excess profits, petitioner claims to be entitled to substitute for its actual net income in the entire base period a theoretical, or constructive, average based upon the assumption that the asserted change in its business occurred before it actually *1192 did. Respondent does not appear to concede that what happened in the last month of the base period constituted a change in business as contemplated by the relief provisions. 1 For our purposes, however, it will be assumed that it did. *41 Notwithstanding this assumption, petitioner can succeed only if it has established both that "the tax computed * * * (without the benefit of this section) results in an excessive and discriminatory tax," and also "what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income * * *." 2 *42 In discussing these requirements, it will prove unnecessary to attempt a nice separation of the second requirement from the first, which *1193 has been paraphrased 3 as a showing that the "taxpayer's net income for those years is an inadequate reflection of its normal operation for the entire [base] period. * * *" 4 Stated from either standpoint, and without belaboring the element of burden of proof, the question narrows to whether on this record we are authorized to presuppose an earlier operation by the petitioner of the different type of business and the existence of accompanying earnings substantially greater than those actually received. *43 The first step in creating the constructive expanded base for which petitioner contends would be to assume that the change in business upon which it relies took place at or before the beginning of the base period and was operative throughout its course. So far the process would be simple. But upon the present facts that premise immediately and automatically requires the anterior assumption of another, namely, the existence of occurrences upon which its expanded business was obviously conditioned. No small part of the difficulty is occasioned by the almost fantastic quality of the gift to petitioner of a ready-made export business, complete with customers, products, protection against competition, and the consequent inevitable profit. This was no mere instance of the withdrawal of competing foreign commerce and the resulting liberation of a previously closed market. Petitioner did not produce a new business, solicit new customers, or discover new sources of salable materials. It was selected to be the heir to all of this under circumstances which would have to be, and in fact were, the product of an unprecedented and unique external situation. It requires no strain upon the imaginative*44 process to assume, even if the record on the subject were less clear, that the world-wide cartel in whose business petitioner participated would not have surrendered its monopolistic position and the ensuing profit voluntarily. It did so for one reason only -- a reason inseparably connected with and incapable of consideration apart from the outbreak of the world conflict in the September previous. To assume that petitioner could have engaged in its expanded business at an earlier period thus carries as a prerequisite the preliminary assumption of petitioner's accession to the export business enjoyed by the cartel. This in turn is inconceivable without the further presupposition of the outbreak of war, which accordingly becomes the necessary premise to the existence of the expanded business. *1194 Whatever may be said of the possibility for present purposes of making the remaining assumptions, we think this last condition clearly inadmissible. The date selected for permissible changes in business was January 1, 1940. Had petitioner's expansion, or at least the plans therefor, developed subsequently, its claim would be automatically eliminated. The date itself, however, can*45 not be without significance. From the legislative history it seems clear that it was chosen as a rough approximation of the time when war distorted the domestic economy and gave rise to the need for a limitation on excessive profits. 5 To assume as a postulate for further hypotheses that the war had its inception before it did is thus fundamentally at variance with the basic concept of the excess profits tax provision. We think this sufficient to dispose of the present question, and find it unnecessary to discuss the many remaining controversies of principle and theory raised by the parties and other participating counsel. For present purposes, we feel it sufficient to conclude that any assumption of higher profits in the base period which requires as an inescapable condition the supposition of the earlier creation of the war situation furnishes no ground for application of the provisions of section 722. Whatever elements of a taxpayer's circumstances, or of general business, may be assumed to have been operative for periods earlier than the actual facts warrant, the war conditions, which gave rise to the enactment of the Excess Profits Tax Act itself, can not be given a predated*46 effect for any purpose. It is undoubtedly true, as petitioner suggests, that section 722 must not be so construed as to eliminate all possibility of relief in all cases. To permit it here, however, would seem to require its application to every other case and not to restrict it to a situation which by any description could be called abnormal. Every corporation which, because of European War orders or of the American*47 rearmament program, embarked upon the production of a different article or extended its business into different fields would be entitled under that construction of section 722 (b) (4) to have its base period earnings expanded to incorporate the assumption that the war and the consequent increased profits had, contrary to history, commenced at a sufficiently early date to be typical of the base period. The very profits which it was the intention of Congress to recapture in substantial part would then escape the excess profits tax on the ground that its application to them would be inequitable. "Normal" profits during the *1195 actual base period do not call for inflation for any such reason in order to prevent unequal or unfair comparison with those made subsequently when the same conditions admittedly influenced corporate earnings. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. SEC. 722. * * * * * * * (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. * * *↩ 2. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME. (a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, except that, in cases described in the last sentence of section 722 (b) (4) and in section 722 (c), regard shall be had to the change in the character of the business under section 722 (b) (4) or the nature of the taxpayer and the character of its business under section 722 (c)↩ to the extent necessary to establish the normal earning to be used as the constructive average base period net income. 3. Tarleau, "Section 722↩: Safety Valve of the Excess Profits Tax," 10 Law and Contemp. Problems, 43. 4. See also Senate Rept. No. 1631, 77th Cong., 2d sess., p. 36: "To come within the general relief provisions, the taxpayer, in existence during the base period, must show that the excess profits tax * * * was excessive and discriminatory and that the average base period net income was not a fair measure of normal earnings. * * *"↩ 5. "In order to eliminate consideration of the effects of the war, it is provided that, in determining the constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, an industry of which it is a member, or taxpayers generally, occurring or existing after December 31, 1939. Thus high war prices, swollen demand, and other factors which would not be normal prior to the imposition of the excess profits tax shall be eliminated in the computation of the normal or average earning capacity of the taxpayer." House Rept. No. 2333, 77th Cong., 2d sess., p. 142.↩