Huguet Fabrics Corp. v. Commissioner

*605 This proceeding arises from the Commissioner's disallowance of petitioner's claim for relief under section 722 (a) and (b) of the Internal Revenue Code with respect to its excess profits tax for its taxable year ended September 30, 1941.

FINDINGS OF FACT.

Part of the facts were stipulated and they are so found.

*161 Petitioner was incorporated on September 23, 1936, under the laws of the State of Delaware, and at all times material herein had its principal place of business in New York, New York.

Petitioner duly filed its excess profits tax return for its fiscal year ended September 30, 1941, with the collector of internal revenue for the third district of New York. For all taxable periods material herein petitioner's income and excess profits tax returns were filed on the basis of a fiscal year ending September 30.

When the petitioner was incorporated in September 1936 under the name name of Huguet Silk Corporation (its name was changed to Huguet Fabrics Corporation on or about October 1, 1941), it succeeded to the business of the Huguet Silk Company, Inc. Petitioner was under new management, however; its capital structure was materially changed from that of its predecessor and its stockholdings were divided between the stockholders of the old company and a new group of investors. Petitioner continued to manufacture the same products as had its predecessor, namely, silk mousselines, silk chiffons and silk marquisettes, all sheer broad woven fabrics, which were produced for, and ultimately*162 sold to, manufacturers of women's party dresses *606 and women's other luxury apparel. The petitioner also manufactured some fabrics which were a combination of silk and rayon, and a very small quantity of novelty woolen fabrics. Petitioner continued its predecessor's practice of marketing its product through jobbers.

Petitioner does not claim to be an acquiring corporation as defined in section 740 of the Internal Revenue Code, nor does it claim to be entitled to compute its average base period net income under Supplement A of the Internal Revenue Code.

Petitioner's net earnings before Federal income tax and nondeductible contributions (unadjusted for any excess profits credit purposes) for the first four years of its operations (which were also its base period years for excess profits tax purposes) are as follows:

The worst of these years was the recession year of 1938, and petitioner's earnings in the next two years were negligible in comparison to those in the first year of its operations. The reasons for the 1938 loss and the low level of earnings in 1939 and 1940*163 include strong competition from fabrics manufactured out of rayon, which were less expensive per weight of fabric than silk, and the lack of demand for such luxury items as were manufactured from petitioner's fabrics. The increase in the production of rayon in the United States corresponded with the decrease in production of silk during the period beginning in 1929, when rayon was first manufactured in large quantities, as is indicated by the following schedule:

*164 *607 The effect of the use of rayon yarn in the manufacture of broad woven fabrics was to permanently supplant part of the demand for broad woven silk fabrics.

Because of petitioner's low level of earnings, its management decided that it should seek new outlets for its products and that it should also embark on the manufacture of such new products as its facilities could successfully handle. In keeping with this decision, petitioner sought to discover new uses for its products and inquired of customers as to the type of fabrics which they might be desirous of obtaining from the petitioner. In the year 1939 petitioner became interested in the synthetic fiber nylon, introduced by the E. I. du Pont de Nemours & Co. of Wilmington. This was a new product. The application for the key patent on this fiber was filed with the United States Patent Office by a du Pont chemist on April 9, 1937, and was assigned by him to the du Pont Company. The company erected a pilot plant for experimental purposes in nylon at Wilmington, Delaware, in July 1938. Its first plant for volume production was erected at Seaford, Delaware, and the production for commercial shipments of nylon was commenced*165 in December 1939. An undergarment specialist employed by petitioner suggested that nylon fabric would be a natural cloth to present to the women's undergarment field because certain of its inherent physical characteristics, such as its expanding qualities, made it particularly adaptable for use in the manufacture of brassieres, girdles, and other foundation garments.

Petitioner contacted the du Pont Company and, while the latter company was primarily interested in women's hosiery market at that time, it recognized the huge potential market elsewhere, including the board woven fabric industry. The two companies worked closely in development and experimental work with respect to nylon fabric.

Since it was particularly interested in women's undergarment field, petitioner contacted various manufacturers of ladies' undergarments with respect to the use of the nylon fabric in their manufacturing process and it explored the possibility of marketing nylon fabrics directly to the manufacturers rather than through jobbers. Early in the calendar year 1940 the petitioner interested the Bali Brassiere Company in the manufacture of brassieres made of nylon fabrics.

For its experimental work *166 petitioner obtained a small quantity of nylon yarn from the du Pont Company. Its first purchases of this yarn in sizable quantities were made in the last 3 months of its fiscal year ended September 30, 1940, as is indicated by the following schedule:

*608 Purchases of nylon yarn October 1, 1939-September 30, 1940

For its fiscal year ended September 30, 1940, petitioner's total net sales of all fabrics were as follows:

All of the customers who purchased petitioner's nylon fabrics during the fiscal year 1940 were jobbers who also purchased its silk products. The total net sales of nylon fabrics for the fiscal year ended September 30, 1940, amounted to $ 16,999.69. These sales were made in the last three months of that fiscal year as follows:

*609 The nylon fabrics which the petitioner manufactured during its base period were sheer fabrics and were classified as chiffons, marquisettes, *168 and mousselines, as were petitioner's silk fabrics. However, because of the inherent physical qualities of the nylon fiber the nylon fabrics could be used in the manufacture of women's undergarments such as brassieres, girdles, and other foundation garments, whereas petitioner's silk fabrics could not be so used.

In weaving nylon fabrics, the petitioner employed the same looms, after minor adjustments, which it used in the manufacture of its silk fabrics, and the same labor was employed in operating these looms. However, the dyeing and finishing processes with respect to the nylon fabrics differed from those with respect to the silk fabrics.

Petitioner did not market any nylon fabrics directly to undergarment manufacturers at any time during its base period, October 1, 1936, through September 30, 1940.

For its fiscal year ended September 30, 1941, petitioner paid an excess profits tax of $ 22,040.33. In computing its excess profits tax liability it employed the invested capital method of determining its excess profits credit which amounted to $ 53,599.62; however, petitioner was entitled to compute its excess profits credit for the fiscal year here involved based on income pursuant*169 to section 713 of the Internal Revenue Code and, in accordance with that section, petitioner's average base period net income for the fiscal year here involved amounts to $ 20,792.93, computed as follows:

OPINION.

The issue presented is whether the petitioner is entitled to any relief from excess profits tax for its fiscal year ended September 30, 1941, under the provisions of section 722 of the Internal Revenue Code. In order to be entitled to relief 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) *610 what would be a fair and just amount representing normal earnings to*170 be used as a constructive average base period net income. ¹

*171 Although the petitioner employed the invested capital method of computing its excess profits credit for the fiscal year here involved, it was entitled to employ the average base period net income method in computing this credit. Accordingly, it is not only entitled, but required, to proceed under section 722 (b) of the Code. Toledo Stove & Range Co., 16 T. C. 1125. It must prove, therefore, within the scope of section 722 (b), that its average base period net income is an inadequate standard of normal earnings. ²

*172 *611 In support of the allegations that the respondent erred in denying petitioner relief from excess profits tax for the fiscal year here involved, the petition contains general allegations of fact which indicate that it is petitioner's position that such events occurred within its experience which qualify as one or more of the factors enumerated in each of the paragraphs (1) to (4), inclusive, of section 722 (b), and which constitute, within the purview of paragraph (5) of that section, factors other than those enumerated in paragraphs (1) to (4), indicating that petitioner's average base period net income is an inadequate standard of normal earnings. Petitioner also relied on all five paragraphs of section 722 (b) in its application for relief on Form 991.

From our examination of the record and briefs, however, it appears that petitioner's case has been developed in such a manner as to indicate that it has placed its main reliance on paragraph (4) of section 722 (b), and with respect to that provision of the Code it is petitioner's main contention that it changed the character of its business during its base period by going into a new and different market with a new*173 and different product. Accordingly, we will first consider this contention.

Petitioner's base period extended from October 1, 1936, to September 30, 1940. Accordingly, within the meaning of section 722, it is entitled to rely on any change in the character of its business which took place prior to October 1, 1940. Wisconsin Farmer Co., 14 T. C. 1021.

As our findings of fact indicate, while the petitioner did some experimental work with respect to the use of the newly developed nylon in the manufacture of broad woven nylon fabrics in the latter part of the calendar year 1939 and the early part of the calendar year 1940, until the last quarter of the last year of the base period the only fabrics it manufactured for sale to its customers were woven out of silk or a combination of silk and rayon yarn (it also manufactured a relatively insignificant quantity of novelty woolen items). Beginning in July 1940, however, petitioner went beyond the experimental stage in the development of nylon fabrics and actually *612 produced nylon fabrics for sale to its customers during the last quarter of its base period. That petitioner took this step is established*174 by the facts stipulated, which indicate the petitioner made its first purchase of nylon yarn in sizeable quantities during that period (1,029 lbs. in July: 1,684 lbs. in August; and 2,037 lbs. in September), and that its first sales (net) of nylon fabric were made during the same period ($ 842.96 in July, $ 5,810.28 in August, and $ 10,346.45 in September).

Although it is not too clear from the record, we believe that the petitioner has established that there were some differences which this nylon fabric possessed which distinguished it from petitioner's silk or combination of silk and rayon fabrics. These differences were specifically referred to by petitioner's general manager as the "high elongation" and "expansion qualities" of the nylon fiber.

The main elements of the alleged change relied on by the petitioner are that it sold these new nylon fabrics to new customers, manufacturers of ladies' brassieres, girdles, and other foundation garments, an outlet for its products which petitioner had never previously employed since its silk fabrics were not adaptable to such a use, and that it sold these fabrics to such manufacturers directly, thus eliminating jobbers' commissions.

We*175 believe that the record does not indicate that such a complete change as claimed by the petitioner took place prior to September 30, 1940. The stipulation shows that petitioner's net sales of all fabrics for the fiscal year ended September 30, 1940, amounted to $ 1,047,381.93. Net sales of nylon fabric amounted to $ 16,999.69, which figure is necessarily included in the total net sales figure. However, the stipulation indicates that all the sales of all fabrics were made to petitioner's customers who purchased its silk fabrics, all of whom petitioner's general manager testified were jobbers. The stipulation also indicates that the first sales to the Bali Brassiere Company were made in October 1940, and the testimony of petitioner's general manager appears to indicate this was the first company which became interested in employing petitioner's nylon fabric in the manufacture of undergarments. While these stipulated facts are in conflict with the testimony of petitioner's general manager, who testified that all of petitioner's sales of nylon fabric for the fiscal year ended September 30, 1940, were made directly to manufacturers of undergarments, the facts stipulated must prevail. *176 Furthermore, the evidence introduced is insufficient to establish that the new fabrics could not be used for any purpose other than the manufacture of undergarments.

From a consideration of all the evidence presented, we believe that the petitioner has not established as a fact that it went into the undergarment field or that it sold its product directly to manufacturers of undergarments during the base period.

*613 We have not overlooked the fact that the manufacture of nylon fabrics for the first time during the base period was a change. However, not every change is sufficient to satisfy the requirements of the statute. As we stated in Wisconsin Farmer Co., supra, at page 1028:

* * * While the statute does not completely define what shall constitute a change in the character of a business, we are willing to accept the general principles outlined in Regulations 112, section 35.722-3 (d), where it is stated:

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*177 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, to be considered substantial, must be reflected in an increased level of earnings which is directly attributable to such change.

The nature or character of a taxpayer's business is at all times subject to many changes which do not necessarily serve to increase the earnings of the business but which in fact may actually result in substantial losses. However, the occurrence of a change in the character of a taxpayer's business for the purposes of securing relief under section 722 is important only if the change directly results in an increase of normal earnings which is not adequately reflected by its average base period net income computed under section 713. It is clear that the critical consideration in granting relief to the taxpayer in such cases as East Texas Motor Freight Lines, 7-Up Fort Worth Co., and Lamar Creamery Co., supra, was the fact that the change*178 was deemed sufficiently important in the taxpayer's business, as reflected by the increase in its earning capacity resulting from the change, to render its average base period net income inadequate as a standard of normal earnings for the entire base period.

While the evidence indicates there were certain differences in the petitioner's nylon product as distinguished from its silk product, the evidence also indicates that both were sheer fabrics and both were classified as chiffons, marquisettes, and mousselines. The evidence presented does not indicate whether or not the nylon fabrics may have been competitive with, or substitutive for, petitioner's silk fabrics and the petitioner introduced no evidence with respect to costs of producing the new fabrics, nor with respect to the market for this product. We must conclude that insufficient evidence was introduced to establish that the change to manufacture nylon fabric by itself is sufficient to qualify as a substantial change within our understanding of the requirements of section 722.

Petitioner introduced no evidence with respect to any change in management or increase in capacity, nor has any issue been raised that it commenced*179 business during or immediately prior to the base period and that such a fact affected its earnings. We hold that the petitioner has not shown the existence of any of the factors enumerated in paragraph (4) of section 722 (b).

*614 With respect to petitioner's claim under the factors contained in paragraphs (1) through (3) and paragraph (5) of section 722 (b), the evidence indicates only that the petitioner's average earnings were very low during the base period, that it suffered a serious loss in 1938, and that its decline in earnings was due in large part to the competition from rayon fabrics and also to the fact that the demand for such luxury items as were manufactured from petitioner's fabrics was very low. As far as we can gather from the record the inroad made into the silk fabrics industry by rayon fabrics was a permanent one, not a temporary one, and rayon replaced part of the demand for silk.

Such evidence does not prove that there was any peculiar or unusual event in the experience of the petitioner either immediately prior to or during the base period, as required by paragraph (1) of section 722 (b), or that there were any temporary circumstances unusual in the case*180 of the petitioner which depressed its business as required by paragraph (2) of that section, or what were the conditions which were generally prevailing in petitioner's industry as required by paragraph (3). We have repeatedly held that the mere existence of a low level of earnings during the base period is insufficient to qualify within the provisions of section 722. Roy Campbell, Wise & Wright, Inc., 15 T. C. 894; Trunz, Inc., 15 T. C. 99; Foskett & Bishop Co., 16 T. C. 456. And likewise precluded is any consideration of paragraph (5) since no evidence was introduced relating to factors other than those enumerated in paragraphs (1) to (4). Cf. George Kemp Real Estate Co., 12 T. C. 943.

Petitioner has not proved that the average base period net income was an inadequate standard of normal earnings as required by section 722 (b). Accordingly, we believe that there is no need for us to consider, nor purpose in a discussion of, a reconstruction of the base period earnings, and we hold that the petitioner is not entitled to relief from excess profits tax in accordance*181 with the provisions of section 722 of the Code.

There is contained in the petition an assignment of error which reads as follows:

The Commissioner of Internal Revenue erred in permitting the Internal Revenue Agent in Charge to usurp the duties and authority delegated by the Congress to the Commissioner of Internal Revenue.

In support of this assignment of error there was alleged in the petition the following facts:

Congress delegated to the Commissioner of Internal Revenue the authority to determine relief under Section 722 of the Internal Revenue Code. Petitioner is informed and believes that the said Commissioner is permitting others to usurp the duties delegated to him by the Congress, in that he permits his servants and agents to deny relief under Section 722 of the Internal Revenue Code.

These allegations were denied by respondent's answer.

*615 We do not fully comprehend the meaning of the above assignment of error. Apparently it is petitioner's position that the procedure employed by the respondent in denying it relief went beyond the provisions of the Code relating to excess profits tax relief. No evidence was introduced with respect to this allegation, nor was any*182 mention of it made on brief. Accordingly, we consider it to have been abandoned by petitioner.

Reviewed by the Special Division.

Findings of Fact and Opinion vacated, August 21, 1952.