Lamar Creamery Co. v. Commissioner

Lamar Creamery Company, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Lamar Creamery Co. v. Commissioner Docket No. 7425 United States Tax Court 8 T.C. 928; 1947 U.S. Tax Ct. LEXIS 214; April 30, 1947, Promulgated *214 Decision will be entered under Rule 50. Petitioner is engaged in the business of manufacturing dairy products and bottling fluid milk at Paris, Texas. It paid excess profits tax for the years 1941 and 1942 and filed applications for relief under section 722, I. R. C., for both years, which applications the Commissioner has disallowed. Held, petitioner failed to establish that its excess profits tax for the calendar years 1941 and 1942, computed without the benefit of section 722, I. R. C., as amended, was excessive and discriminatory because of the factors mentioned in section 722 (b) (2), but has established that its said tax was excessive and discriminatory because of the factors mentioned in section 722 (b) (4); held, further, petitioner has established a fair and just amount representing normal earnings mentioned in section 722 (a) to be used as a constructive average base period net income in lieu of the actual average base period net income otherwise determined. S. G. Winstead, Esq., and J. P. Jackson, Esq., for the petitioner. Irene F. Scott, Esq., J. D. Bierman, Esq., and R. E. Maiden, Jr., Esq., for the respondent. Black, Judge. BLACK *215 *929 This proceeding is for a review of the respondent's disallowance of petitioner's applications for excess profits tax relief under section 722 of the Internal Revenue Code, as amended, for the taxable years ended December 31, 1941 and 1942, in the respective amounts of $ 4,264.48 and $ 47,756.89. The notice of disallowance was sent and the petition for redetermination was filed in accordance with section 732 of the code. Attached to the notice of disallowance is a "Statement" by the respondent, which is in part as follows: Excess Profits Tax Liability for the Taxable Years Ended December 31, 1941 and 1942 Year Liability Assessed Overassessment Deficiency [1941] $ 4,264.48 $ 4,264.48 (1) None None [1942] 47,756.89 47,756.89 (2) None None *216 (1) Assessed: Original account #400308 $ 4,544.74 Less previous allowance 280.26 Net assessment $ 4,264.48 (2) Assessed: Original account #99349 $ 48,403.76 Less previous allowance 646.87 Net assessment $ 47,756.89 It is held that you have not established: (1) that your normal operations in the base period were interrupted or diminished because of the occurrence, either immediately prior to or during the base period, of events unusual and peculiar in your experience; (2) that your average base period net income does not reflect normal earnings for the entire base period because of the change in character of your business during the base period; and (3) that there were any other factors affecting your business which may reasonably be considered as resulting in an inadequate standard of your normal earnings during the base period. In view of the foregoing it is held that you have not established that the taxes computed for the taxable years 1941 and 1942 under subchapter E of chapter 2 of the Internal Revenue Code without the benefit of section 722 of the Code result in excessive and discriminating taxes within the provisions of *930 sections 722*217 (a) and 722 (b) of the Code, and that you have not established what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of an excess profits tax based upon a comparison of normal earnings and earnings during the excess profits tax years 1941 and 1942. Accordingly, the claims for refund contained in your applications for relief under section 722 of the Internal Revenue Code for the years 1941 and 1942 which were filed on September 15, 1943 under Bureau Serial Numbers 19686 and 19687, are disallowed. Notice of such disallowances is hereby given in accordance with the provisions of section 732 of the Internal Revenue Code. Petitioner, in its amended petition, assigns as error the following: 4. The Commissioner of Internal Revenue committed error in denying to petitioner relief from excess profits taxes in accordance with the provisions of Section 722 (b) (1), (2), (4) and ( 5) of the Internal Revenue Code. In schedule B of the above mentioned applications for relief, sometimes referred to herein as claims for refund, petitioner did not check section 722 (b) (2) as one of the "reasons" for relief, but *218 did check as reasons section 722 (b) (1), (4), and (5). In view, however, of the "general information" furnished in the applications, the respondent does not object to petitioner assigning error as to section 722 (b) (2). In its brief, petitioner apparently abandons its claims as far as section 722 (b) (1) and (5) are concerned and relies primarily upon section 722 (b) (2) and (4). FINDINGS OF FACT. Petitioner is a corporation, organized during 1928 under the laws of the State of Texas for the purpose of engaging in the business of manufacturing dairy products and bottling fluid milk. Its principal place of business is Paris, Texas. Its returns for the years in question were filed with the collector for the second district of Texas at Dallas. Petitioner is entitled to use the excess profits credit based on income pursuant to section 713 of the code, as amended. Its "base period" as that term is defined in section 713 (b) is the period consisting of the four calendar years 1936 to 1939, inclusive. Its "average base period net income" as that term is defined in section 713 (d) (1) and determined under subsection (f) (without the benefit of section 722) is $ 11,397.59, and petitioner*219 used this amount in computing its excess profits tax in its excess profits tax returns for the years 1941 and 1942. Petitioner filed with the respondent applications for relief under section 722 on Form 991 for the calendar years 1940, 1941, and 1942. Petitioner paid no excess profits tax for the calendar year 1940. In these applications petitioner claimed a "constructive average base period net income" under section 722 (a) for each of the years 1941 *931 and 1942 of $ 45,515.53 in lieu of the above mentioned actual average base period net income of $ 11,397.59. Petitioner's claims filed for the taxable years 1941 and 1942 incorporate by reference the material submitted in the claim filed for the year 1940. Under schedule B of the claims, filed for all three years, petitioner, among other things, stated: After two years of operation under program heretofore outlined, taxpayer agreed it would be advisable to set up a substation at Greenville, Texas, for the purpose of buying milk in truck tanks for the daily use of the Paris plant. In order to attempt to defray the expense of operation of this expected source of supply, taxpayer thought it advisable to distribute fluid milk*220 in the City of Greenville. Installation of equipment was made and operations were begun in 1935. This entailed contacting farmers and selling them on the idea of producing whole milk for market instead of sour cream. The undertaking did not prove successful. The losses sustained in 1936 were $ 4,361.22 and in 1937 $ 6,144.09. In the spring of 1936 the Carnation Company opened a plant at Sulphur Springs, Texas. As previously stated in this memorandum, milk production had not been developed in this section; so the Carnation Company paid farmers in this locality fifteen to twenty per cent more than the market price in order to encourage farmers to produce milk. This procedure caused taxpayer to meet such competition thereby being forced to expend funds over and above the normal price. A summary of the excess costs paid by taxpayer is as follows: 1936: 305,106 lbs at 3 cents $ 9,153.18 1937: 347,583 lbs. at 3 cents 10,427.49 1938: 288,595 lbs. at 3 cents 8,657.85 1939: 397,015 lbs. at 3 cents 11,910.48 Four year average $ 10,037.25 The condition outlined above forced the taxpayer to conclude that discontinuance of the substation plant at Greenville was advisable*221 although seemingly badly needed as a source of supply. Taxpayer having been forced to meet Carnation Company's prices although not being able to increase the price of products manufactured, it seemed advisable to seek a new product whereby some of the losses might be recovered. This necessity brought forth the idea to manufacture ice cream mix products. In the spring of 1938 the development of the idea to include the manufacture of ice cream mix was put into being. A representative was sent into the field to contact farmers and counter freezer operators. On January 1, 1939 a separate department was installed to provide for the manufacture of the new product. The records disclose that this department has had steady and continuous growth in succeeding years. Bedford B. Harlan originally organized petitioner and is its president and general manager. Harlan is a chemical engineer, having studied chemical engineering for three years at the University of Kansas. He was associated with three ice cream companies from 1921 until he organized petitioner in 1928. *932 At the time petitioner was organized the supply of raw milk in and around Paris, which is in Lamar County, was inadequate. *222 The principal crop in that area was cotton. In order for petitioner to establish its business and enlarge its operations on a profitable basis, it undertook a program of education and encouragement of farmers to buy calves, raise feed, improve their herds, and increase their production of milk. Petitioner was unable to obtain a sufficient supply of milk to operate on a satisfactory basis until 1936. During this period there were a number of independent companies operating in this area and all of these companies followed the same pattern of developing milk production. Subsequently all of these companies were sold to national companies, with the exception of petitioner and Meadolake Foods, Inc., of Sherman, Texas, hereinafter sometimes referred to as Meadolake. Facts Bearing Upon Section 722 (b) (2) Ground for Relief. In 1935 the Carnation Co., hereinafter sometimes referred to as Carnation, established a plant at Sulphur Springs, Texas, which is approximately 40 miles south of Paris in the adjoining county of Hopkins. At the time the Carnation plant was opened, petitioner was buying milk in that area and continued to buy milk in competition with Carnation throughout*223 the base period. After opening its plant at Sulphur Springs, Carnation faced the situation of developing and enlarging its operations in the same manner as petitioner had done by paying the normal price for milk and going into a long period of education and encouragement of farmers to improve their herds and thereby increase milk production. Carnation, however, did not adopt this policy, but did adopt a policy of developing its milk supply by paying more than the market prices then paid in its territory. The policy adopted by Carnation forced petitioner to pay prices for milk in excess of prices previously paid. Petitioner continued to pay these excess prices throughout the base period. In many instances Carnation paid more for milk than the milk products sold for. Because of Carnation's buying policy, petitioner could not have operated successfully without making changes. Petitioner opened a plant at Greenville, Texas, in 1935. Greenville is about 31 miles west of Sulphur Springs. The reason for opening the Greenville plant was that at the time petitioner was not getting sufficient milk for its Paris plant, and the idea was conceived of establishing a milk station in Greenville*224 for the purpose of buying and cooling milk there and hauling it to Paris for processing. In addition, petitioner decided to pasteurize and bottle some milk there and sell it *933 in Greenville with the hope that this would help pay the operating cost of that station. Carnation, however, was likewise operating in the Greenville area and petitioner had to buy its milk in that area in competition with Carnation. It was because of this competition and the resulting losses that petitioner decided to close its Greenville plant on December 31, 1937. During 1936 and 1937 petitioner conducted its operations under three main departments, namely, the pasteurizing department, the condensing department, and the Greenville plant. The operating profits or (losses) from these departments were as follows: [1937] Pasteurizing department $ 5,553.18 $ 9,958.66 Condensing department 2,080.83 (1,152.01) Greenville plant (3,838.12) (6,030.17) Miscellaneous sales 129.21 253.08 Operating profit 3,925.10 3,029.56 Taking into consideration other income and deductions, the losses of the Greenville plant for 1936 and 1937 were $ 4,361.22 and $ 6,144.09, respectively. *225 The type of plant established by Carnation was the kind that would be expected to be permanent. This plant had a capacity of about 200,000 gallons of milk per day, as compared to petitioner's capacity of 50,000. After the establishment of the Carnation plant in Sulphur Springs in 1935, Carnation became a permanent competitor of the petitioner in the milk-buying field. Every company which operated in the same area with Carnation was likewise affected by competition with Carnation, particularly Meadolake and Texas Milk Products Co. Because of Carnation's buying policy, Meadolake was forced to discontinue its operations in the territory where it was in competition with Carnation. Texas Milk Products Co. was forced to discontinue its plant at Sulphur Springs on account of competition with Carnation, and to pay higher prices generally throughout its buying territory. The policy of Texas Milk Products Co. was to pay the same general scale throughout its entire buying territory, which included the Sulphur Springs, Mt. Pleasant, Longview, Tyler, and Texarkana areas, all in Texas. Petitioner has not shown that its average base period net income is an inadequate standard of normal earnings*226 because petitioner's business was depressed in the base period because of temporary economic circumstances unusual in the case of the petitioner or because of the fact that an industry of which petitioner was a member was depressed by reason of temporary economic events unusual in the case of such industry. *934 Facts Bearing Upon Section 722 (b) (4) Ground for Relief. In 1935, 1936, and 1937 petitioner sold small quantities of ice cream mix to ice cream counter freezer operators. These operators were usually small concerns such as drug stores. Usually petitioner sold such operators milk and the operators would buy ice cream mix from some other concern. However, in some instances where petitioner's customer could not obtain ice cream mix from such other concern, petitioner made small sales of ice cream mix to such customer solely as an accommodation. This practice of accommodation sales was followed by almost every manufacturer of ice cream products in Texas. Prior to 1938 petitioner had never solicited any customers for ice cream mix. In 1938 petitioner decided to establish an ice cream mix business, with the primary idea of soliciting ice cream manufacturers. *227 Petitioner had determined that many small ice cream manufacturers making less than 1,000 gallons a year could profitably buy ice cream mix from an established ice cream mix manufacturer. During 1938 petitioner sold 490,515 pounds of ice cream mix and received therefor $ 34,744.61. At the beginning of 1939 it established a separate department in its business, called the ice cream mix department. During that year petitioner sold 994,834 pounds of ice cream mix and received therefor $ 64,770.97. The resulting operating profit from petitioner's separate departments during 1938 and 1939 was as follows: [1939] Pasteurizing department $ 6,255.11 $ 940.39 Condensing department 902.77 7,547.52 Ice cream mix department 1,531.13 Miscellaneous sales 483.05 436.53 Operating profit 7,640.93 10,455.57 During the base period years ice cream production in Texas was as follows: Year Gallons [1936] 7,524,000 [1937] 8,331,000 [1938] 9,663,000 [1939] 9,988,000 During the base period years the average price per cwt. paid producers by condenseries for milk testing 3.5 per cent butterfat f. o. b. factory in the United States was as follows: [1936] $ 1.56 [1937] 1.57 [1938] 1.25 [1939] 1.24 *228 *935 At the beginning of 1938 petitioner owned ice cream mix equipment consisting of machinery, vaults, cans, and trucks, which equipment had cost petitioner $ 921.41. During 1938 petitioner established a laboratory for making accurate tests in connection with the manufacture of ice cream mix, which laboratory included a so-called Minnesota reactor. At this time petitioner did considerable analytical work in connection with the manufacture of ice cream mix. During 1938 and 1939 it purchased additional ice cream mix equipment costing $ 4,580.84 and $ 2,152.95, so that by the end of the base period (December 31, 1939) it owned ice cream mix equipment which had cost a total of $ 7,655.20. In 1938, following the establishment of its ice cream mix business, petitioner adopted new methods of merchandising. New customers were solicited for ice cream mix in 1938 and 1939. A great deal of the soliciting was done in new territory. The largest expansion of petitioner's ice cream mix business resulted from sales to ice cream manufacturers who had not been petitioner's customers prior to 1938. The establishment of the ice cream mix business changed petitioner from a small business *229 operator to one of the largest in the Paris area. Before the end of 1939 petitioner expanded its ice cream mix business from a few miles around Paris to east Texas, and parts of Arkansas, Louisiana, Oklahoma, and Mississippi. The production of ice cream mix required the same general type of labor as the production of petitioner's other products, but the ice cream mix department heads had to be trained, particularly in the manufacture of ice cream mix. These men were given special training by Harlan, and some of them were sent to A. & M. College at College Station, Texas, for short courses. In connection with Harlan's previous experience from 1921 to 1928 with ice cream manufacturing, Harlan made a study of the costs which go into the manufacture of ice cream mix. The establishment of the ice cream mix department helped petitioner's other departments to dispose of their products because the ice cream mix department could use such products. For example, petitioner's other departments manufactured sweet cream and serum solids, some of which were used by the ice cream mix department and, therefore, constituted an additional outlet over and above their regular sales, reducing cost of*230 the other departments. The establishment of the ice cream mix department also enabled petitioner to adopt a more aggressive buying policy and to maintain better its position in the price field. The ice cream mix business flourishes in the months from March 15 to October 15, and usually May through September are the best months for such business. May through September are likewise months of *936 peak production of raw milk. Thus, petitioner was able to purchase more milk during these peak months by reason of the fact that these months are also peak months of ice cream consumption. Petitioner's ice cream mix department had not reached by the end of the year 1939 the earning level which it would have reached if petitioner had made this change two years earlier. Petitioner's actual sales of ice cream mix in 1938 and 1939 show that in 1939 sales increased more than 100 per cent in volume over 1938. Actual sales by months in 1938 and 1939 show a corresponding increase. If petitioner's ice cream mix business had been established two years earlier, that is to say, in 1936 rather than in 1938, petitioner would have manufactured and sold 2,000,000 pounds of ice cream mix in 1939. *231 On the same assumption petitioner would have manufactured and sold 1,506,600 pounds in 1936, 1,668,200 pounds in 1937, and 1,934,920 pounds in 1938. Ample markets existed in each of these years for the said number of pounds of ice cream mix petitioner would have manufactured and sold if this department of petitioner's business had been established two years earlier. On the basis of the above number of pounds of ice cream mix which petitioner would have manufactured and sold if its ice cream mix business had been established two years earlier, petitioner's sales per unit and in the aggregate, petitioner's cost of sales per unit and in the aggregate, and petitioner's operating profit per unit and in the aggregate for each of the base period years would have been as follows: PER UNIT Sales Cost of sales Year Pounds Amount Ingredients Processing [1936] 1,506,600 $ 0.0819089 $ 0.0626874 $ 0.0045000 [1937] 1,668,200 .0824337 .0630300 .0045000 [1938] 1,934,920 .0708329 .0501832 .0035000 [1939] 2,000,000 .0651073 .0497820 .0035000 AGGREGATE [1936] Same $ 123,403.95 $ 94,444.84 $ 6,779.70 [1937] Same 137,515.90 105,146.65 7,506.90 [1938] Same 137,055.99 97,100.48 6,772.22 [1939] Same 130,214.60 99,564.00 7,000.00 *232 PER UNIT Sales Cost of sales Operating profit Year Operating Total [1936] $ 0.0090000 $ 0.0761874 $ 0.0057215 [1937] .0090000 .0765300 .0059037 [1938] .0080000 .0616832 .0091497 [1939] .0080000 .0612820 .0038253 AGGREGATE [1936] $ 13,559.40 $ 114,783.94 $ 8,620.01 [1937] 15,013.80 127,667.35 9,848.55 [1938] 15,479.36 119,352.06 17,703.93 [1939] 16,000.00 122,564.00 7,650.60 In 1936, 1937, 1938, and 1939 it would have been possible for petitioner to obtain the necessary supplies and ingredients to produce the reconstructed volume and it could have been sold at profitable prices. Petitioner's average base period net income is an inadequate standard of normal earnings because during the base period petitioner changed the character of its business by adding a new product in the form of *937 ice cream mix and the average base period net income does not reflect the normal operation for the entire base period of petitioner's business. Petitioner's excess profits tax liability computed without the benefit of section 722 results in an excessive and discriminatory tax. Petitioner's constructive average base period net income to be used in*233 computing the credit for the taxable years 1941 and 1942 is the amount of $ 15,975.53, computed as follows: [1939] Net income as reported $ 2,859.72 $ 2,524.46 $ 5,420.70 $ 11,570.82 Eliminate actual profit from ice cream mix 1 765.56 1,531.13 Balance 2,859.72 2,524.46 4,655.14 10,039.69 Add constructive profit from ice cream mix as determined above 8,620.01 9,848.55 17,703.93 7,650.60 Constructive net income 11,479.73 12,373.01 22,359.07 17,690.29 Constructive average base period net income (general average) 15,975.53 OPINION. The question presented is whether petitioner is entitled to any relief from excess profits tax for the calendar years 1941 and 1942 under the provisions of section 722 of the Internal Revenue Code, as amended, the material provisions of which are in the margin. 2 *234 *938 Under the statute petitioner must establish (1) that the tax computed without the benefit of section 722 results in an excessive and discriminatory tax and (2) a fair and just amount representing normal earnings to be used as a constructive average base period net income. See East Texas Motor Freight Lines, 7 T. C. 579. If petitioner establishes these two requirements, then the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income of $ 11,397.59 otherwise determined under the statute. In this particular instance the $ 11,397.59 was determined under section 713 (f) of the code. Petitioner's actual average base period net income for the four base period years was $ 5,593.92, but by reason of the provisions of 713 (f), commonly known as the "growth formula," it is entitled to use and has used as a credit in determining its excess profits tax for each of the taxable years an average base period net income of $ 11,397.59. In determining (2) above no regard shall be had to events or conditions affecting petitioner, the industry of which it is a member, or taxpayers generally*235 occurring or existing after December 31, 1939, with certain exceptions not applicable here. We shall first consider whether petitioner has established (1) above. Under section 722 (b) the tax computed without the benefit of section 722 "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" of the existence of one or more of the factors thereafter mentioned in subsection (b). The parties agree that petitioner is entitled to use the excess profits credit based on income pursuant to section 713. The parties differ on whether petitioner has shown the existence of the factors mentioned in subsections (b) (2) and (4) of the statute. We first take up petitioner's contention that it is entitled to relief under section 722 (b) (2). The essential elements of this subsection are: (1) the "business of the taxpayer" (or the business of the industry of which it is a member) must be "depressed"; (2) the depression of business must be caused by a temporary economic circumstance; and (3) such circumstance*236 must be "unusual in the case of the taxpayer" or of its industry. Petitioner does not contend that the industry of which it was a member was depressed. Petitioner does contend, however, that under section 722 (b) (2) it has shown that its own business *939 was depressed in the base period because of its competition with Carnation; that this competition was a temporary economic circumstance unusual in the case of petitioner; that if it had not been for this competition petitioner would not have suffered the losses at its Greenville plant and would not have had to pay as much for its ungraded B milk as it did pay; and that because of these things its average base period net income is an inadequate standard of normal earnings. We find ourselves unable to agree with these contentions. It is true that when Carnation opened its plant at Sulphur Springs it paid more for milk than petitioner and other milk companies in that territory had been paying and as a result thereof petitioner had to pay more for its milk thereafter. But can such competition be considered as a temporary economic circumstance unusual in the case of petitioner or of the industry of which petitioner was a member? *237 We do not think it can be so considered. Competition is present in almost any business. Instead of it being something unusual, it is quite common. It is of the very essence of our capitalistic system. Petitioner's competition with Carnation can hardly be considered as a temporary event, notwithstanding Harlan's testimony that it was temporary. Carnation had come to Sulphur Springs to stay. It built a plant at Sulphur Springs having a capacity four times that of petitioner's plant, and, in our opinion, it became in a very real sense a permanent competitor of the petitioner in the milk-buying field. We do not think petitioner has shown that its average base period net income is an inadequate standard of normal earnings because of the factors mentioned in subsection (b) (2), and we have so found as one of our ultimate findings of fact. See sec. 35.722-3 (b), Regulations 112; Monarch Cap Screw & Manufacturing Co., 5 T. C. 1220; and Fish Net & Twine Co., 8 T. C. 96. Petitioner introduced in evidence a schedule showing a summary of milk prices per 100 pounds of 4.5 per cent butterfat test for the years 1936 to 1939, *238 inclusive, paid by Meadolake Foods, Inc., of Sherman, Texas, one of its competitors. Petitioner also introduced a schedule showing a comparison of petitioner's average cost and Meadolake's average cost of ungraded milk purchased per 100 pounds of 4.5 per cent butterfat test. In view of our holding that on the facts petitioner has not proved its right for relief under section 722 (b) (2), we have not incorporated these schedules in our findings of fact, as it is believed they would serve no useful purpose. Petitioner does not claim these facts would be relevant under section 722 (b) (4), which we presently discuss. Section 722 (b) (4) Relief. Petitioner also relies upon section 722 (b) (4) and contends that it has shown that during the base period petitioner changed the character of its business by adding a new product in the form of ice cream mix, *940 so that its average base period net income did not reflect the normal operation for the entire base period; that petitioner's business did not reach, by the end of the base period, the earning level which it would have reached if it had made this change in the character of its business two years before it did *239 so; and that because of this showing petitioner's average base period net income is an inadequate standard of normal earnings. We think the evidence offered by petitioner supports these contentions and we have so found in our findings. Section 722 (b) (4) provides in part that the tax shall be considered to be excessive and discriminatory if the taxpayer's 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 * * * 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 * * * made the change in the character of the business two years before it did so, it shall be deemed to have * * * made the change at such earlier time. For the purposes of this subparagraph, the term "change in the character of the business" includes * * * a difference in the products * * * furnished * * *. In 1938 petitioner commenced to manufacture and sell ice cream*240 mix on a quantity basis. We think this represented a difference in the products furnished and hence a change in the character of petitioner's business during the base period. Section 35.722-3 (d), Regulations 112, relating to "Commencement or change in character of business," reads in part: * * * * A change in the character of the business for the purposes of section 722 (b) (4) must be substantial in that the nature of the operations of the business affected by the change is regarded as being essentially different after the change from the nature of such operations prior to the change. No change which businesses in general are accustomed to make in the course of usual or routine operations shall be considered a change in the character of the business for the purposes of section 722 (b) (4). * * * A change in the character of the business includes changes resulting from the following activities: * * * * (2) A difference in the products or services furnished. A product or service is different from another product or service if the trade custom or practice treats it as a product or service of a different class. A mere improvement in the product or service does not constitute a *241 difference in the product or service. For example * * * Another taxpayer manufactured and sold a variety of products, some under patents it had developed. During the base period it engaged in extensive research, developed new products, perfected and obtained a patent, and employed new marketing methods, enabling it to sell a leading product never before sold in the new markets. A difference in the products furnished is deemed to have resulted. *941 We think the addition to its business by petitioner in 1938 of a new product, namely, ice cream mix in quantity production, brings petitioner within the ambit of the foregoing regulations. We think the same reasoning would apply here as we used in 7- Up Fort Worth Co., 8 T. C. 52, where we held that the character of taxpayer's business, that of a soft drink manufacturer manufacturing a drink called "7-Up," was changed by the addition of a new product, "Nesbitt's Orange Beverage." It is not enough, however, for petitioner to establish merely that during the base period it changed the character of its business. It must also establish that "the average base period net income does not reflect the normal*242 operation for the entire base period of the business." East Texas Motor Freight Lines, supra. The actual earning level reached by petitioner in its ice cream mix department for the calendar year 1939, which was the last year of the base period, was $ 1,531.13. Petitioner contends that it has proved that, if it had made this change in the character of its business two years earlier, its operating profit from its ice cream mix department for the last year of its base period would have been $ 17,475.90. Harlan testified that in his opinion if the change had been made two years earlier petitioner would have manufactured and sold 3,000,000 pounds of mix during 1939. This estimated production of 3,000,000 pounds forms the basis for the calculation of a reconstructed profit in 1939 for ice cream mix of $ 17,475.90. During that year it actually manufactured and sold 994,834 pounds for $ 64,770.97, which was at the rate of $ .0651073 per pound. The respondent contends that Harlan's estimate of 3,000,000 pounds is not justified on the facts that were known at the end of the base period. In his brief the respondent insists "that any amount greater than 2,000,000*243 pounds is clearly and obviously unreasonable on the proof adduced." Petitioner actually manufactured and sold 490,515 pounds in 1938 and 994,834 pounds in 1939, which represents an increase in 1939 of 504,319 pounds over 1938. If this result had been pushed back two years and an additional two years added at the same rate of increase, the production for 1939 would have reached approximately 2,003,472 pounds. We are, therefore, of the opinion that Harlan's estimate of 3,000,000 pounds is too high. We think these figures are too optimistic when only facts existing at the end of 1939 are taken into consideration. And it is only these that we can take into account. We can not take into account the swollen demand which was created in the war years. It was this very sort of thing which Congress sought to avoid in the enactment of the last sentence of section 722 (a), to which we have already referred. Of this prohibition, House Report No. 2333, 77th Cong., 2d sess., had this to say at page 142: *942 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*244 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. We, therefore, agree with the respondent that the evidence does not warrant a finding of any amount greater than 2,000,000 pounds of ice cream mix at the end of 1939, and we have so found in our findings of fact. In arriving at the reconstructed operating profit on a production of 2,000,000 pounds, we have used the same selling price per pound of $ .0651073 which petitioner actually experienced in 1939 on the sale of the 994,834 pounds. The respondent contends in his brief that we should find that of the 2,000,000 pounds, 490,515 pounds should be considered as if it had been sold to small counter freezers at $ .0702662 per pound and the balance, or 1,509,485 pounds, should be considered as if it had been sold to ice cream manufacturers at $ .0600896 per pound. The record does not support this contention. We*245 think the evidence shows that the 2,000,000 pounds could have been sold for $ .0651073 per pound and we have so found in our findings. As to the cost of sales, the respondent contends in his brief that for 2,000,000 pounds we should find an ingredient cost of $ .049782 per pound, a processing cost of $ .0035 per pound, and an operating cost of $ .008 per pound. We think the evidence supports this contention and have made a finding to that effect. On the basis of these costs and a selling price per pound of $ .0651073 we have found that the operating profit on 2,000,000 pounds would have been $ 7,650.60. This amount represents the earning level petitioner would have reached in its ice cream mix department by the end of the base period if it had made the change two years earlier. Since the amount is in excess of the actual earning level that was reached by the end of the base period, petitioner, under the statute, "shall be deemed to have * * * made the change at such earlier time." Before it can be determined whether the average base period net income does reflect the normal operation for the entire base period, we think it is necessary to determine what the normal operation for*246 the entire base period would have been on the assumption, which must be made, that the change occurred two years earlier, and then compare that normal operation with the average base period net income of $ 11,397.59. We have found that on the assumption that petitioner would have manufactured and sold 2,000,000 pounds of mix in 1939, it would have manufactured and sold 1,506,600 pounds in 1936, 1,668,200 pounds *943 in 1937 and 1,934,920 pounds in 1938. 3 We have also found that the selling price per pound in 1938 was $ .0708329. This was the actual selling price of the 490,515 pounds which petitioner actually manufactured and sold in 1938. We have also found that the selling prices per pound in 1936 and 1937 were $ .0819089 and $ .0824337, respectively. This is in accordance with Harlan's testimony to that effect and is in harmony with the average price of milk paid producers in the United States during those years as compared with the same prices paid in 1939. The parties are agreed upon the ingredient costs per unit set out in our findings. The processing and operating costs per unit which we have found in our findings are those suggested by the respondent and are substantially*247 the same as the costs requested by petitioner, except that they are a little higher, due to our finding of a much lower production for those years than petitioner had requested. The evidence showed that those costs increased as production decreased and vice versa. These findings all add up to the result that, if petitioner had made the change two years earlier, an assumption which must be made, the normal operation of petitioner's ice cream mix business for the entire base period would have shown operating profits for those years of $ 8,620.01, $ 9,848.55, $ 17,703.93, and $ 7,650.60, respectively. When these amounts are added to petitioner's income from its other departments and compared with the average base period net income of $ 11,379.59, we think petitioner has shown that its average base period net income does not reflect the normal operation for the entire base period and that its average base period net income is an inadequate standard of normal earnings. It follows that its tax computed without the benefit of section 722 shall be considered excessive and discriminatory and we have so found as ultimate facts in our findings. *248 Much of what we have already found goes to the establishment of (2) mentioned at the beginning of this opinion, namely, a fair and just amount representing normal earnings to be used as a constructive average base period net income under section 722 (a). Petitioner has requested us to find that its constructive average base period net income to be used in lieu of its actual average base period net income for both the taxable years here involved is $ 37,536.39, computed as follows: *944 [1937] Net income as reported $ 2,859.72 $ 2,524.46 Eliminate: Losses from operation of Greenville plant 4,361.22 6,144.09 Actual profit from ice cream mix Balance 7,220.94 8,668.55 Add: Excess cost of milk due to competition 11,129.32 5,879.15 Constructive profit from ice cream mix 18,251.63 20,614.95 Constructive net income 36,601.89 35,162.65 Constructive average base period net income (general average) [1939] Net income as reported $ 5,420.70 $ 11,570.82 Eliminate: Losses from operation of Greenville plant Actual profit from ice cream mix 765.56 1,531.13 Balance 4,655.14 10,039.69 Add: Excess cost of milk due to competition 5,740.44 9,618.99 Constructive profit from ice cream milk 30,850.84 17,475.90 Constructive net income 41,246.42 37,134.58 Constructive average base period net income (general average) 37,536.39 *249 The respondent, in his brief, while contending that petitioner has not established that it is entitled to reconstruct its average base period net income for Greenville book losses or the commencement of the manufacturing of ice cream mix, nevertheless argues that, even conceding that petitioner had established its right to both (b) (2) and (b) (4) grounds, its constructive average base period net income would be $ 11,787.51 to be used in lieu of the $ 11,397.50 allowed petitioner under section 713 (f). Respondent, in his brief, gives the details of his computation in arriving at the above figure of $ 11,787.51 constructive average base period net income, but they need not be set out here. Suffice it to say we do not agree with the computation of respondent, nor do we agree with the one which petitioner has made. As disclosed in our findings of fact, we are unable to find that petitioner has established a constructive average base period net income of $ 37,536.39. Instead of this amount, we have found in the last paragraph of our findings that petitioner has established a constructive average base period net income for the taxable years 1941 and 1942 in the amount of $ 15,975.53. *250 In making this finding, we have not permitted petitioner to eliminate the losses from the operation of the Greenville plant or to add as constructive net income any amount for excess cost of milk due to competition, as petitioner has done in its above computation, for the reason that in our opinion petitioner has not shown that its average base period net income is an inadequate standard of normal earnings because of the factors mentioned in section 722 (b) (2). The respondent in his computation of the constructive average base period net income has added as "Constructive profit from ice cream mix" the amounts of $ 5,501.97 for 1936; $ 5,570.61 for 1937; $ 2,886.21 for 1938; and $ 2,606.98 for 1939. These amounts are considerably less than the amounts which petitioner contends should be added as constructive profit from ice cream mix, and we think they are too low. For reasons which we have already stated, we have found that the constructive profit from ice cream mix for each of the base period years was $ 8,620.01, $ 9,848.55, $ 17,703.93, and $ 7,650.60, respectively. We *945 hold that these amounts should be added in place of the amounts contended for by the parties. *251 These computations have been made in our findings and, as there indicated, we have found that petitioner's constructive average base period net income to be used in computing credit in the taxable years 1941 and 1942 is $ 15,975.53 instead of $ 37,536.39 contended for by petitioner and instead of $ 11,787.51 computed by respondent in his brief. In his brief the respondent suggests that, once having determined the constructive net income for the year 1939, "a much more reasonable approach to a reconstruction" for all the base period years would be to use a general business index method, as was done in East Texas Motor Freight Lines, supra. On January 23, 1947, the Excess Profits Tax Council E. P. C. 8, Internal Revenue Bulletin No. 6, page 4, refers to Mimeograph 5807, 1945 C. B. 273, and to our holding in the East Texas Motor Freight Lines case, and says in part: "Only when no better, more appropriate, data are available should a general business index be used." Petitioner has supplied that "better, more appropriate, data" in the instant case, namely, it has proved "detailed reconstruction of sales, costs, or expenses" (Bulletin, *252 part V, subpart II (C) (4) (b) (i), page 110 and quoted in the East Texas case at 7 T. C. 594) for all the base period years. That being true, we are of the opinion and so hold that a general business index method should not be used in the instant case. Petitioner's excess profits tax liabilities for the calendar years 1941 and 1942 should be redetermined by using a constructive average base period net income credit for both years of $ 15,975.53 in lieu of the actual average base period net income of $ 11,397.59 which petitioner used in its excess profits tax returns for those years. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. Since petitioner did not have a separate department for ice cream mix in 1938, both parties have estimated the actual profit for that year as being one-half of the actual profit for the year 1939.↩ 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 a 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 * * *. (b) Taxpayers Using Average Earnings Methods. -- 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 -- * * * * (2) the business of the taxpayer was depressed in the base period because of temporary economic circumstances unusual in the case of such taxpayer or because of the fact that an industry of which such taxpayer was a member was depressed by reason of temporary economic events unusual in the case of such industry, * * * * (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 purposes 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. * * * * * * *↩ 3. This finding is arrived at by applying to 1939 poundage the ratio that production of ice cream in Texas during the years 1936, 1937, and 1938 bears to such production in 1939. This method was used by both petitioner and respondent in their reconstructions, as will be seen from the following quotation from respondent's brief: "The respondent has made a reconstruction of petitioner's sales of ice cream mix on the basis of sales of 2,000,000 pounds in 1939. The pounds sold in the years 1936, 1937 and 1938 are arrived at by the same method used by petitioner, i. e., applying to 1939 poundage the ratio that production of ice cream in Texas in the years 1936, 1937, and 1938 bears to such production in 1939." As both parties use the same general method in their suggested reconstructions, we have adopted it.↩