Harlan Bourbon & Wine Co. v. Commissioner

*97 This case involves relief under section 722 of the Internal Revenue Code, as amended, from excess*289 profits tax. Petitioner filed an application for relief for each of the calendar years 1941, 1942, and 1943, relying exclusively upon section 722 (b) (2). Each application requested an increase in the excess profits credit through the determination of a constructive average base period net income.

Petitioner paid excess profits tax in the amounts of $ 693.34 for 1941, $ 18,155.01 for 1942, and $ 68,613.22 for 1943. If petitioner's claim were allowed in full, the revised liability would be zero for 1941 and 1942, and $ 46,685.38 for 1943.

Respondent rejected the claim for refund asserted in the application for relief. The same letter also gave petitioner formal notice of certain final determinations of its income and excess profits tax liabilities for the years 1938 through 1943 on the basis of various adjustments independent of section 722, and included the determination of a deficiency in excess profits tax for the year 1943 in the amount of $ 5,921.52.

The assignments of error in the petition are directed to the disallowance *98 of petitioner's claims for relief under section 722. Petitioner takes no exception to any of the adjustments of taxable income or to any changes*290 in the petitioner's tax liability resulting therefrom, as stated in the deficiency notice.

FINDINGS OF FACT.

The petitioner is a corporation, organized under the laws of Kentucky in March, 1934, to engage in business as a wholesale dealer in alcoholic liquors and wines. Its principal office and place of business is at Harlan, Kentucky.

The petitioner filed its Federal income and excess profits tax returns for the calendar years 1934 to 1943 with the collector of internal revenue at Louisville, Kentucky. It has always used the accrual basis of keeping its books and reporting its income and deductions.

The Twenty-first Amendment to the Constitution of the United States, repealing the Eighteenth Amendment, was proclaimed on December 5, 1933, as ratified. Early in 1934 the State of Kentucky legalized the manufacture and sale of liquor in that state. Many distillers, wholesalers, and retailers went into the liquor business in that state in 1934, 1935, and 1936.

Under Government regulations, whiskey must be aged in bond for a period of four years before it can be bottled as a bottled in bond whiskey. About that much aging is required before it reaches what is considered to be a palatable*291 state.

A large part of the liquor sold in 1934, 1935, and 1936 was supplied by blends made up of newly distilled grain alcohol or neutral spirits and a small percentage of aged whiskey. A supply of merchandise was thus available for liquor wholesalers generally and petitioner was able at all times to procure all that it required. Distillers maintained production on a year-round basis during this period. Normal practice was to produce only in the spring and fall seasons. After a sufficient stock was built up this usual practice was resumed.

One reason for the favorable volume of business of Kentucky wholesalers in 1934, 1935, and 1936 was the increase in the number of retailers doing business during that period. A substantial volume of sales represented the original stocking of the retailers. In 1937, 1938, and 1939 the sales of wholesalers were limited to the replacement of stocks which had been sold to the ultimate consumers.

The volume of liquor sales in Kentucky during the first few years after repeal included sales to residents of nearby states, including Ohio, Virginia, and West Virginia, where the sale of liquor on a legal basis did not begin until some time after it began*292 in Kentucky.

Whenever one of the neighboring states legalized the sale of liquor, the demand from such state was supplied directly by the distilleries without the intervention of any Kentucky wholesaler or retailer.

*99 After the supply of fully aged whiskey became more plentiful, the market derived from residents of other states was reduced, and the number of retailers to which sales could be made ceased to increase. Kentucky wholesalers were then required to take a decreased margin of profit to maintain their sales volume. Many wholesalers were unable to compete successfully in the resulting market. The number of wholesalers licensed to deal in alcoholic beverages in Kentucky declined from about 70 on July 1, 1937, to about 38 on July 1, 1938, with little or no change in their number during the last year and a half of the base period.

Distillers have always followed the practice of selling a portion of their current production through the issuance of warehouse receipts. Such receipts are negotiable instruments which make it possible for any bearer to become the owner of a stated quantity of liquor while it is still on the property of a distillery or stored in a public warehouse.

*293 Distillers normally realize more for whiskey sold in case lots to wholesalers than when sold in bulk through the medium of warehouse receipts.

The volume of warehouse receipt sales increased from 1934 until 1937 and 1938, when the total supply of fully aged liquor came to be more in line with demand. This was due to the fact that many of the independent distillers lacked sufficient capital to carry substantial stocks of whiskey for their own account and were forced to sell warehouse receipts to procure operating capital. Many of such sales were made at low prices, and some represented distress sales.

After warehouse receipts became available in substantial quantities, many wholesalers and retailers entered the market for the whiskey so available, and then had it bottled under their own labels. Retailers frequently sold whiskey so obtained to the consuming public at prices below those obtaining for the same or comparable whiskey bearing distillers' labels which the distillers were seeking to sell to wholesalers in case lots.

Kentucky law required that all whiskey bottled for sale within the state be channeled through a wholesaler. It was necessary for retailers to have whiskey *294 that they had acquired through the purchase of warehouse receipts "cleared" by the wholesalers. Clearing consists of procuring the release of whiskey from storage upon the payment of Government taxes and bottling charges of the distiller. The clearing charge made by wholesalers covered the use of the wholesaler's name and its trouble for attending to the necessary papers. The prevailing clearing charges were substantially less than the regular mark-up that wholesalers obtained on the resale of distillers' brands, and wholesalers who performed clearing services did so primarily to secure or retain customers among the retailers. As warehouse *100 receipts increased in quantity, competition became severe in the entire liquor industry. New brands were introduced in an effort to bolster sales and meet competitive prices. Charges for clearing services reached as low as 25 cents, and, in certain instances, 10 cents, per case in 1937 and 1938.

Petitioner and other wholesalers endeavored to maintain sales volume by reducing their margin of profit and through the allowance of more attractive rebates and discounts to retailers in the form of free goods and otherwise. They also paid*295 higher commissions for the same purpose.

Petitioner's management did not choose to purchase warehouse receipts in volume for its own account to bolster sales in the face of increased competition, and elected, instead, to push the better known advertised brands which carried a higher profit for the wholesaler.

Petitioner has always confined its activity to the eastern section of Kentucky. Some wholesalers had the exclusive right to sell the products of certain large distillers throughout the State of Kentucky.

According to the official Government records, the total production of whiskey in the United States and the total amount of whiskey withdrawn for consumption in each of the calendar years 1934 to 1939, inclusive, was:

The following schedule shows the total tax gallons of whiskey stocks in bonded warehouses in the United States at the several dates indicated therein:

*296 Respondent determined petitioner's average base period net income under section 713 (e) of the code. For the purpose of computing petitioner's excess profits credit for 1941, its average base period net income was determined to be $ 9,447.91. For computing the credit for 1942, the average base period net income was determined to be $ 12,039.86. For computing the credit for 1943, the average base period net income was determined to be $ 11,809.89. Petitioner's application for excess profits tax relief proposed a constructive average base period net income of $ 26,149.26.

*101 The following schedule shows the total year-end net worth, net sales, gross profit, and net income of the petitioner for each of the calendar years 1934 through 1939:

In compliance with the Bureau requirement that any taxpayer claiming*297 membership in a depressed industry furnish the names and addresses of other members of such industry, the petitioner's original application for relief with respect to the calendar year 1941 listed seven wholesale liquor firms by name, and stated that they were "probably" serving the Harlan district. The combined total net sales and net income as reported for Federal tax return purposes by five of such wholesalers that derived substantially all their income from liquor wholesaling activities were as follows:

The following schedule shows the total combined net sales, net income, and net worth of the four largest listed corporations in the distilled and rectified spirits industry for the years 1936 through 1939:

The following schedule shows selected data taken from the three schedules shown immediately*298 above, and from the schedule showing whiskey withdrawals in the United States, after conversion of such data to index figures using the 1936-1939 average as equal to 100:

*102 The following schedule shows the percentage relationship which net income bore to net sales in each of the years 1936 through 1939 for the petitioner, the five competitive wholesalers described above, the four largest listed corporations in the distilled and rectified spirits industry, and all listed corporations in such industry:

The following schedule shows the percentage relationship which net income bore to net worth in each of the years 1936 through 1939 for the petitioner and the industry corporations described in the preceding schedule:

Petitioner's business was not depressed in the base period either because of temporary economic circumstances unusual in the case of the petitioner or because of temporary economic events unusual in the case of the industry of which the taxpayer was a member, nor does its average base period net income, as determined with the benefit of section 713 (e), constitute an inadequate standard of its normal earnings for any of such years, within the meaning of section 722.

Petitioner is not entitled to excess profits tax relief under section 722.

OPINION.

Petitioner seeks relief under section 722 (b) (2) of the Code ¹ as to excess profits taxes for 1941, 1942, and 1943, alleging *103 that its excess profits tax liability*300 for those years is excessive and discriminatory and its average base period net income originally returned for the base period years is an inadequate standard of normal earnings because the business of petitioner was depressed in the base period on account of a depression in the industry of which petitioner is a member resulting from a temporary economic event unusual in the case of that industry, namely, a ruinous trade war among wholesale liquor dealers which began in 1937 and was not ended until after March 1940.

*301 To prevail under the issues here the petitioner must show that its average base period net income is an inadequate standard of normal earnings, that this was because petitioner's business was depressed in the base period, and that the cause of this depression was a temporary economic event unusual in the petitioner's industry, and must establish what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income.

Petitioner has not shown that its average base period net income, as computed with the benefit of section 713 (e), is "an inadequate standard of normal earnings." This term refers to a standard which falls below that established over a reasonable period of time and under normal conditions. Monarch Cap Screw & Manufacturing Co., 5 T. C. 1220. The early years of the revived liquor industry in Kentucky was a period of large demand and small supply. Profits were large in relation to sales and to net worth in 1934, 1935, and 1936. By June 30, 1937, the stocks of whiskey in bonded warehouses had reached a level which was not greatly increased in the next three years. Supply was overtaking*302 the demand. Prices fell, as was inevitable. The easy profits of the early years diminished. The statistics shown in our findings of fact indicate a decline in the last two years of the base period in the relation of net income to net sales in the combined experience of five of petitioner's competitors named by it in its application for relief under section 722. Also, they show a decline in such years in the ratio of net income to net worth and of net income to net sales in the combined experience of the four largest corporations in the liquor and distilled spirits industry and in the experience of all listed corporations in the industry. Petitioner's sales were fairly constant in dollar volume through the base period with some falling off in 1938, and with a substantial recovery in 1939. Petitioner's gross profits were fairly level in 1935, 1936, and 1937, and fell lower in 1938 and 1939. Net income was roughly one-third of gross profit in 1935 and 1936, about one-sixth in 1937, and vanished in 1938 and 1939. Net income for 1936 was nearly half the year-end net worth. In 1937 it was 18.35 per cent. Thereafter it was about zero. Net income in 1934 and 1935 approximated the*303 year-end net worth and for 1936 was 47.25 per cent of net worth. This was a higher ratio of profits than *104 was shown by its competitors. If the higher earnings in 1936 offset the lower earnings in the later years, the average is not necessarily an inadequate standard of normal earnings. The actual average of the earnings of petitioner for the base period was $ 9,106.26. The average base period net income was determined by the respondent with adjustments made under section 713 (e) with respect to 1939, the only base period year of deficit. The average base period net income as so determined for the purpose of computing the excess profits credit for 1941 was $ 9,447.91, for 1942 was $ 12,039.86 and for 1943 was $ 11,809.89. The correctness of these computations is not challenged by the petitioner. This average base period net income is approximately 20 per cent of petitioner's net worth in the base period, an income ratio which compares favorably with the ratio of earnings to net worth of all listed corporations in the liquor industry and of the four largest in the industry, as shown in the statistics in our findings of fact. We can not say from the evidence that this*304 is an inadequate standard of normal earnings for petitioner.

Petitioner relies principally upon its contention that a ruinous trade or price war existed in the base period years in the liquor industry in Kentucky. Treasury Regulations 112, section 35.722-3 (b), recognizes that a ruinous price war involving a taxpayer's industry, including the taxpayer, during several of the base period years, in which members of the industry sustained severe losses as a result of sales below cost, may be a temporary economic event unusual in the case of the industry and constitute a basis for relief under section 722 (b) (2). On the other hand, competition can not be considered a temporary economic event unusual in the case of a taxpayer or its industry, as competition is a normal factor in almost any business. See Lamar Creamery Co., 8 T. C. 928, 939.

Business fluctuations, also, are normal conditions. A mere failure to maintain a given level of earnings does not establish a depression of earnings within the meaning of section 722. George Kemp Real Estate Co., 12 T. C. 943. When the revival of the liquor industry was getting under*305 way in 1934 and immediately thereafter, an enormous demand for legal liquor existed and the supply available consisted only of medicinal stocks of the prohibition era. Retailers entering the newly revived business sought to stock their shelves, thus creating a further abnormal demand until this was accomplished. Distillers operated on a year-round basis instead of the previously customary spring and fall seasonal basis. Many distillers entering the business were not sufficiently capitalized to afford to wait the four-year aging period necessary to bottle their product in bond, and resorted to selling a part of their warehouse receipts to procure operating capital. Retailers acquired some of these. Petitioner says the wholesalers were squeezed between the distillers and the retailers. The distillers *105 were requiring the pushing of their own brands and the retailers who had acquired warehouse receipts were demanding that the wholesalers clear the liquor for bottling under the retailers' brands for a nominal clearing fee. The wholesaler had to do this or lose the retailer as a customer. The sale of warehouse receipts, says petitioner, depressed the price of whiskey in*306 1937 and 1938 to the point where any reasonable profit was eliminated. Gifts and commissions became necessary to effect sales. The effect of the conditions in the industry was to increase petitioner's cost of doing business. At the higher cost it was unable to make profits. The then Commissioner of Revenue for Kentucky testified that during this period most of the wholesalers of liquor made little or no profit and some went out of business. The number of wholesalers licensed in Kentucky declined from about 70 on July 1, 1937, to 38 on July 1, 1938, with little change during the remainder of the base period.

Early in 1940 the Kentucky Legislature enacted legislation which required a minimum mark-up on liquor sales from producers to wholesalers and from wholesalers to retailers and prohibited donations, free goods, bribery, and rebates. This legislation was upheld by the Kentucky Court of Appeals in Reeves v. Simons, 289 Ky. 793; 160 S. W. (2d) 149. Petitioner argues that this decision judicially determined that a "price war" or "ruinous competition" existed in Kentucky in the base period years. That court commented*307 upon evidence tending to show that, due to price cutting, chaos existed in the trade, and held that the act regulating the liquor traffic to eliminate ruinous competition was constitutional as a reasonable exercise of the police power. The only issue before the court was the constitutionality of the statute, and the court's comments on the evidence before it are not determinative of the facts to be found from the evidence before us for the purpose of construing a revenue statute in litigation between other parties. See Guaranty State Bank of Greenville, Texas, 12 B. T. A. 543; First National Bank in Dallas v. Commissioner, 45 Fed. (2d) 509, affirming 16 B. T. A. 719; certiorari denied, 283 U.S. 845.

Three witnesses testified on behalf of petitioner as to the conditions existing in the liquor industry in Kentucky in the base period years. They said there was fierce and destructive competition without regard to costs, in which most wholesalers made little or no profit and some incurred losses and went out of business, and that it was almost impossible to make any*308 money. Petitioner argues that from their testimony it is clear that there existed a ruinous price war within the meaning of the regulations. We do not agree. Their testimony has been given due consideration in connection with the other evidence of record, but we think the evidence, as a whole, is not sufficient to *106 demonstrate more than keen competition, a factor which must be considered normal in the liquor industry.

Petitioner confined its business to the eastern part of Kentucky. In this it may have been at a disadvantage in competing with some other wholesalers who had the exclusive right to sell throughout the state the products of certain large distillers.

Although a number of the wholesalers licensed in Kentucky dropped out of business in the year July 1, 1937, to June 30, 1938, there was no further decline in the ensuing year. The statistics furnished by the respondent show that five wholesalers, competitors of petitioner, had in 1936 a lower ratio of net income to net sales than petitioner, that both petitioner and these competitors had a decline in this ratio in 1937, but the competitors, on the average, had no further decline while petitioner's income fell*309 to nothing. Where, as here, many people enter a newly revived industry, in the hope of large profits, competition will ultimately eliminate the least efficient. When supply caught up with demand, that is what happened here. The competition became too stiff for the marginal dealers. If the conditions were as chaotic and ruinous as petitioner represents them to be, we would expect to see a further reduction in the number of surviving wholesalers in 1939, and the profits of petitioner's competitors should show a reduction in 1938 and 1939 comparable to that experienced by petitioner. We can not conclude from the evidence that petitioner has established that a "ruinous price war," as distinguished from keen competition, depressed the industry of which petitioner was a member in the base period years.

There is a further failure in petitioner's proof in that it has not established "a fair and just amount representing normal earnings to be used as a constructive average base period net income." Petitioner's application for excess profits tax relief proposed a constructive average base period net income of $ 26,149.26. This was computed by adopting the sales volume for 1936 as normal*310 for the remainder of the base period and applying the average percentage of profit on its sales for 1934, 1935, and 1936, or 5.2997 per cent. We think the assumptions that 1936 sales and 1934 to 1936 percentages of profit on sales were normal are not warranted in the circumstances. 1934 was the first year of the revived industry. The demand was large and the supply small, profits were easy and the percentage of profit high. The succeeding years of 1935 and 1936 were still abnormal as to profits. Supply had not caught up with demand. When this occurred, perhaps in 1937 or 1938, the industry was overcrowded with dealers; some were forced out; others survived with little or no profits in the years 1938 and 1939; and others, as indicated by the statistics referred to above, derived a measure of profits, though somewhat less than in the early lush years. Sales in excess of those actually made by petitioner *107 could not reasonably be expected, nor a percentage of profit equal to that for 1934 to 1936. The constructive average base period net income proposed by petitioner is, therefore, not a fair and just amount representing normal earnings. While we might determine some*311 other figure from the evidence, as in Lamar Creamery Co., supra, and Dyer Engineers, Inc., 10 T. C. 1265, we are not called upon to do so in view of the failure of petitioner's proof in other respects.

We conclude that petitioner is not entitled to relief under section 722 of the code.

Decision will be entered for the respondent.