Opinion
Docket No. 18441.
1954-04-30
CHARIS CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Colman B. Stein, Esq. , and S. Walter Kaufman, C. P. A. , for the petitioner. Jules I. Whitman, Esq. , for the respondent.
Petitioner, shortly prior to its base period, introduced a new type of garment in its manufactured line; brought about a change in method of retail selling from office fittings of its garments to home fittings, to better suit the convenience of customers; and transferred certain company-owned branch offices to franchise distributors. Held, only the introduction of the new garment constituted a change in the character of the business within the meaning of section 722(b)(4), Internal Revenue Code. Petitioner's constructive average base period net income determined. Colman B. Stein, Esq., and S. Walter Kaufman, C. P. A., for the petitioner. Jules I. Whitman, Esq., for the respondent.
The petitioner seeks relief for excess profits tax liability for the taxable years 1942, 1943, and 1944 under section 722(b)(4) of the Internal Revenue Code. It asks for a reconstructed average base period net income of $145,634.61 and for the refunds resulting from a credit based on such average. The issue is whether, under the facts adduced, petitioner is shown to be entitled to relief under the provisions of the cited section.
FINDINGS OF FACT.
Petitioner is a corporation organized under the laws of the State of New York on September 22, 1915, under the name of ‘Fifth Avenue Corset Company,’ which name was changed in 1928 to Charis Corporation.
Since its incorporation, petitioner has kept its books and filed its Federal income and excess profits tax returns on the accrual basis, using the calendar year.
Petitioner's principal place of business is Allentown, Pennsylvania, and its corporation income and declared value excess-profits tax returns and corporation excess profits tax returns for the year ended December 31, 1942, 1943, and 1944 were filed with the collector of internal revenue for the first district of Pennsylvania.
Petitioner paid excess profits taxes for the years 1942 to 1944, inclusive, as follows:
+----------------+ ¦1942¦$25,138.21 ¦ +----+-----------¦ ¦1943¦64,539.18 ¦ +----+-----------¦ ¦1944¦97,959.47 ¦ +----------------+
Petitioner's excess profits credit for the year ended December 31, 1942, was $113,101.64, being 95 per cent of average base period net income of $119,054.36. Its excess profits credit for the year ended December 31, 1943, was $112,998.24, being 95 per cent of average base period net income of $118,945.52. Its excess profits credit for the year ended December 31, 1944, was $113,069.08, being 95 per cent of average base period net income of $119,020.08.
Petitioner's sales, gross profit, and net income for the years 1921 to 1939, inclusive, were as follows:
+--------------------------------------+ ¦Year¦Sales ¦Gross profit¦Net income¦ +----+---------+------------+----------¦ ¦1921¦$124,790 ¦$52,732 ¦$4,785 ¦ +----+---------+------------+----------¦ ¦1922¦174,575 ¦80,053 ¦17,282 ¦ +----+---------+------------+----------¦ ¦1923¦218,177 ¦92,157 ¦16,579 ¦ +----+---------+------------+----------¦ ¦1924¦316,005 ¦123,082 ¦16,531 ¦ +----+---------+------------+----------¦ ¦1925¦564,897 ¦248,873 ¦49,939 ¦ +----+---------+------------+----------¦ ¦1926¦1,001,790¦522,276 ¦174,359 ¦ +----+---------+------------+----------¦ ¦1927¦1,387,545¦835,442 ¦387,598 ¦ +----+---------+------------+----------¦ ¦1928¦1,973,718¦1,222,242 ¦591,543 ¦ +----+---------+------------+----------¦ ¦1929¦2,396,050¦1,391,139 ¦591,502 ¦ +----+---------+------------+----------¦ ¦1930¦2,527,883¦1,533,804 ¦637,926 ¦ +----+---------+------------+----------¦ ¦1931¦2,203,714¦1,404,216 ¦369,514 ¦ +----+---------+------------+----------¦ ¦1932¦1,499,126¦958,639 ¦117,883 ¦ +----+---------+------------+----------¦ ¦1933¦1,319,299¦811,472 ¦212,900 ¦ +----+---------+------------+----------¦ ¦1934¦1,364,143¦799,406 ¦179,859 ¦ +----+---------+------------+----------¦ ¦1935¦1,368,544¦798,235 ¦174,121 ¦ +----+---------+------------+----------¦ ¦1936¦1,332,928¦771,756 ¦152,321 ¦ +----+---------+------------+----------¦ ¦1937¦1,327,858¦747,782 ¦127,384 ¦ +----+---------+------------+----------¦ ¦1938¦1,099,742¦632,588 ¦61,135 ¦ +----+---------+------------+----------¦ ¦1939¦1,130,252¦645,311 ¦96,345 ¦ +--------------------------------------+
From the commencement of its business in 1915, petitioner's products were sold to the ultimate purchaser only through corsetieres (salesladies) selling at customers' homes. No sales were made through regular retail businesses. From 1915 to 1924 petitioner manufactured only made-to-measure, made-to-order corsets. It discontinued this operation in 1925 or 1926.
In 1924 petitioner developed a new type corset with patented features. The figure was controlled in this type of corset by an inner belt, laces, boning, and rigid fabric. This type of corset, known as the Charis garment, was the only product manufactured by petitioner from 1925 or 1926 until 1935.
In 1935 petitioner commenced the manufacture and sale of a line of garments designated as the Swavis line. This was in addition to the line already manufactured and sold by the petitioner. The Swavis garments were elastic-controlled, as distinguished from the lacer-control of Charis, and contained no inner belt or laces, and very little boning.
The Charis garments are more attractive to and more adaptable to the needs of a woman with a figure, problem, one having a large or collapsed abdomen needing firm control. The Swavis garments are more attractive to the type of woman who has sufficient muscle tone so that her figure does not require the strong and definite control of the Charis garment.
There are more women in the class to whom the Swavis garment appeals than in the class who necessarily must use the garment of the Charis type. A woman who requires control of a large abdomen and smoothing out of figure line cannot wear an elastic-control garment which takes on the shape of the natural figure, but wears a lacer-control garment to mold the figure and keep it contained.
The Swavis garment is attractive to the class of women who can do without a corset altogether but who wear a garment to smooth out the line of the figure so that dresses will fit better and for women who are still young enough in figure and who do not require the elaborate design of belt and lacer used in the Charis garment. The consumer recognized that the elastic-control garment was new and had different uses. It was the trade custom or practice to treat an elastic-control garment of the Swavis type as a product of a different class from a Charis type.
Sales of Swavis were made largely by size. Although some fitting was necessary, it was not as complicated as the fitting of Charis. Petitioner's total sales, sales of Charis and sales of Swavis, in dollars, for the years 1933 through 1939, were as follows:
+-----------------------------------------------------------------------------+ ¦Year¦Total sales ¦Index (1939=¦Charis ¦Index (1939=¦Swavis ¦Index (1939=¦ ¦ ¦ ¦100) ¦ ¦100) ¦ ¦100) ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1933¦ $1,319,299¦116.72 ¦$1,298,872¦163.10 ¦ ¦ ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1934¦*1,364,143 ¦120.69 ¦1,359,500 ¦170.72 ¦ ¦ ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1935¦*1,368,544 ¦121.08 ¦1,260,512 ¦158.29 ¦$101,837¦30.49 ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1936¦1,332,928 ¦117.93 ¦1,194,828 ¦150.04 ¦138,100 ¦41.36 ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1937¦1,327,859 ¦117.48 ¦1,134,696 ¦142.49 ¦193,163 ¦57.85 ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1938¦1,099,742 ¦97.29 ¦853,288 ¦107.15 ¦246,454 ¦73.81 ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1939¦1,130,253 ¦100.00 ¦796,328 ¦100.00 ¦333,925 ¦100.00 ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1933¦$20,427 ¦ ¦ ¦ ¦ ¦ ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1934¦4,643 ¦ ¦ ¦ ¦ ¦ ¦ +----+-------------+------------+----------+------------+--------+------------¦ ¦1935¦6,195 ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+
Includes miscellaneous sales:
1 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. * * *(b) TAXPAYERS USING AVERAGE EARNINGS METHOD.—The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because—* * * * * * *(4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the 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 competitior, with the result that the competition of such competitor was eliminated or diminished. * * *
Petitioner's total sales, sales of Charis and sales of Swavis, in units, for the years 1933 through 1939, were as follows:
+-----------------------------------------------------------------------------+ ¦Year¦Total ¦Index (1939= ¦Charis ¦Index (1939= ¦Swavis ¦Index (1939= ¦ ¦ ¦sales ¦100) ¦ ¦100) ¦ ¦100) ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1933¦$356,476 ¦131.60 ¦$356,476¦188.87 ¦ ¦ ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1934¦306,030 ¦112.96 ¦306,030 ¦162.13 ¦ ¦ ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1935¦339,991 ¦125.49 ¦306,732 ¦162.51 ¦$33,259¦40.48 ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1936¦299,239 ¦110.45 ¦260,415 ¦137.97 ¦38,824 ¦47.25 ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1937¦298,884 ¦110.32 ¦247,763 ¦131.26 ¦51,121 ¦62.21 ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1938¦240,314 ¦88.70 ¦179,183 ¦94.93 ¦61,131 ¦74.40 ¦ +----+----------+--------------+--------+--------------+-------+--------------¦ ¦1939¦270,872 ¦100.00 ¦188,732 ¦100.00 ¦82,140 ¦100.00 ¦ +-----------------------------------------------------------------------------+
Petitioner reached a normal level of sales for the Swavis garment in 1939.
From the commencement of petitioner's business through 1936, sales were made at the customer's home by corsetieres. The customer then went to the local office for a fitting, on a prearranged appointment. No fittings were made by the corsetieres—they were all made by trained fitters in the offices. Fitting a corest is similar to fitting a suit. The garment is tried on and checked to see whether it fits properly at bust, waist, and hips, whether it is of proper length above and below waistline, and whether it requires any alterations. A garment with the same bust size is made in a variety of hip measurements, a variety of lengths below the waistline of different types, 14 or 15 different belts, and with other variations.
Prior to 1936 the petitioner felt that the decline in its sales was due to general business depression. In that year it engaged a firm to make a study of its business, which firm recommended that it change its custom of requiring customers to come to the place of business of the seller by appointment for fittings, and arrange to have such fittings in the home of the customer. Petitioner's experience showed that customers failed to keep appointments for office fittings; that they came for fittings at any time convenient to themselves; that customers had to wait for hours to be fitted; and that customers were dissatisfied and sales were lost.
In 1937 petitioner decided that discontinuance of office fittings and the training of corsetieres to do home fittings was desirable. In 1937 petitioner tested this home service program in Baltimore and Syracuse. By the end of 1937, after 7 or 8 months of operation of home service in these two places, petitioner concluded that tests showed very satisfactory results, and thereupon instituted a program of home service in both its company-owned and franchise distributor offices.
In March 1938, 5 offices were changed to home service. During the balance of 1938, 30 more offices were changed to home service, and during 1939, 29 offices were changed to home service. By December 31, 1939, the great majority of offices had been changed to home service.
Petitioner sold its garments to franchise distributors or company-owned branch offices. During the period involved there were 90 outlets or selling organizations through which petitioner's garments were sold to users. Of these 90 businesses only 12 were owned by petitioner, the balance being businesses operated by franchise distributors. In all of the 90 businesses selling petitioner's products there were some 2,000 corsetieres employed. The great majority of these corsetieres were employed and paid by the franchise distributors.
Under petitioner's method of operation its garments were sold and billed to franchise distributors or company-owned offices. The prices charged each were the same. Garments sold to a franchise distributor were retailed by it through its employed corsetieres and any profit resulting was the property of that business. Garments sold to a company-owned office were paid for by such office, such payments being taken up on the petitioner's books as gross income. At the end of each year any net profit or loss by the company-owned office was reflected on petitioner's books in its profit and loss account. According to petitioner's books, the company-owned offices were losing money if the profit on sales to those offices is disregarded.
In changing over to home service it was necessary for petitioner to supervise the training of corsetieres in fitting methods. Company representatives were sent to various offices to train groups of corsetieres, regular schools were established, and demonstration books were prepared. The training program worked fairly effectively in the Baltimore and Syracuse test offices.
Corsetieres or salesladies were paid on a commission basis. Many of them were housewives who wanted part-time work. There was regularly a high turnover in personnel.
When petitioner commenced a complete changeover to home service, some difficulty arose, particularly with older corsetieres who were reluctant to assume added responsibility of fitting. Many corsetieres rebelled and some quit. Change to home service caused some disruption in petitioner's organization. It took a considerable amount of time to train corsetieres throughout the country to fit garments, and slowed down their work.
By December 1939 sales of the Charis garments in the Baltimore and Syracuse test offices had reached a level of sales which was approximately the same as the level of sales in these two offices prior to the change to home service. The experience in the Baltimore and Syracuse offices does not necessarily reflect the effect of the change on petitioner's over-all earnings. The actual sales figures for these two offices are not available; nor are the sales figures for other individual offices available.
At the time the decision was made for complete changeover to home service it was anticipated that it would take 2 or 2 1/2 years for an office to reach a level of sales under home service equal to that which it had immediately prior to the change. Offices were being changed to home service all through 1938 and 1939.
Decrease in Charis sales was not as a result of the introduction of the Swavis line of garments.
Petitioner's gross sales to its branch offices for the years 1936 to 1939, inclusive, were as follows:
+--------------+ ¦1936¦$251,000 ¦ +----+---------¦ ¦1937¦292,000 ¦ +----+---------¦ ¦1938¦175,000 ¦ +----+---------¦ ¦1939¦115,000 ¦ +--------------+
Petitioner's gross profit percentages on sales for the years 1936 to 1939, inclusive, were as follows:
+--------------+ ¦ ¦Per Cent ¦ +----+---------¦ ¦1936¦57.89 ¦ +----+---------¦ ¦1937¦56.3 ¦ +----+---------¦ ¦1938¦57.5 ¦ +----+---------¦ ¦1939¦57.1 ¦ +--------------+
In 1937 petitioner decided to transfer the company-owned branch offices to franchise distributors. Seven offices were transferred in 1938 and one in 1939. Sales by petitioner to the branch offices after their transfer to franchise distributors continued to be as good as or better than when they were operated by company personnel.
During the base period there were four other major direct selling corset companies: The Berger Bros. Company, The Spirella Company, The NuBone Company, and Kellogg Corset Company. During this period petitioner and the above named four companies agreed to report their monthly sales to the accounting firm of Haskins & Sells, and agreed that this firm would combine the five figures into one grand total and report this grand total to each of the five companies. Petitioner received monthly during the base period from Haskins & Sells a figure purporting to show the combined annual sales of its four competitors. These figures and the index based thereon are as follows:
+---------------------------------+ ¦Year¦Combined annual sales¦Index ¦ +----+---------------------+------¦ ¦1936¦$3,904,464 ¦100.60¦ +----+---------------------+------¦ ¦1937¦4,015,806 ¦103.47¦ +----+---------------------+------¦ ¦1938¦3,687,998 ¦95.03 ¦ +----+---------------------+------¦ ¦1939¦3,881,031 ¦100.00¦ +---------------------------------+
The introduction of the Swavis line constituted a substantial difference in the products furnished by petitioner, caused a material increase in petitioner's normal level of earnings, and was a change in the character of petitioner's business within the purview of section 722(b)(4) of the Internal Revenue Code.
The change from office fitting to home fitting did not increase petitioner's normal level of earnings and was not a change in the character of petitioner's business within the meaning of section 722(b)(4). The change resulted, however, in an abnormal variation in petitioner's earnings. The effect of the change is not measurable in particular items of income and expense, and the amount of the variation in earnings caused by the change is not ascertainable.
The transfer of eight company-owned offices to franchise distributors did not cause an essential difference in the nature of petitioner's operations and was not a change in the character of petitioner's business within the meaning of section 722(b)(4). A change in the ownership of 8.9 per cent of a company's sales outlets is not an unusual event. An event of this type and magnitude would ordinarily occur within a 4-year interval.
Sales of the Swavis garment were normal in 1939. Normal sales of the Swavis garment would have varied from the 1939 level of $333,925 in accordance with the sales index of petitioner's four competitors. If sales of the Swavis garment had been normal throughout the base period it would have increased petitioner's gross sales by $197,829 in 1936, by $152,349 in 1937, and by $70,874 in 1938.
The additional sales would not have increased petitioner's administrative and a number of other fixed costs, but would have increased petitioner's net income in 1936, 1937, and 1938.
Petitioner's excess profits credit allowed to it for the years 1942, 1943, and 1944, computed under section 713 of the Code, results in an excessive and discriminatory tax. Petitioner's average base period net income is an inadequate standard of normal earnings. A fair and just amount, representing normal earnings to be used by the petitioner as a constructive average base period net income, is an amount equal to $15,800 more than petitioner's average base period net income otherwise determined without the benefit of section 722 of the Internal Revenue Code.
OPINION.
BRUCE, Judge:
Petitioner is entitled to use the excess profits credit based on income pursuant to section 713, Internal Revenue Code. It contends, however, that the computation of its excess profits tax by use of its excess profits credit based on income without the benefit of section 722 results in an excessive and discriminatory tax. It undertakes to establish three distinct changes in the character of its business which might qualify it for relief under section 722(b)(4).
It also undertakes to establish what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income.
Introduction of the Swavis Garment.
Petitioner contends, first, that the introduction of the Swavis line was ‘a difference in the products or services furnished,’ which qualifies as a ‘change in the character of the business' within the purview of subsection (b)(4). There can be no doubt that, a difference in the products or services furnished may occur through the addition of a new product. But, in order for a taxpayer to qualify for relief under subsection (b)(4) because of either ‘a difference in the products or services furnished’ or ‘a change in the operation or management of the business,’ it must show that the change was substantial as measured by two basic tests which are set forth in respondent's Bulletin on Section 722, at pages 48 and 50, and quoted with approval in Central Produce Co., 18 T. C. 267, 274:
(i) The nature of the operations must be essentially different after the change from the nature of the operations prior to the change; and
(ii) There must be a higher level of earnings which is directly attributable to the change. We shall consider these tests in the order named to determine whether or not the alleged ‘change’ was substantial.
For the addition of a new product to result in an essential difference in the nature of the taxpayer's operations, such addition must represent more than a usual or customary event in the type of business in which the taxpayer is engaged. Cf. Permold Co., 21 T. C. 759, where the taxpayer during its corporate life had produced a variety of cast aluminum products, switching from one to another. See also Triangle Raincoat Co., 19 T. C. 548. The addition must ordinarily represent more than the addition of a new product to a line of varied products. Cf. Stonehard Co., 13 T. C. 790. Moreover, the added product must be substantially different from the product or products previously furnished; mere improvement is not sufficient. Cf. Pelton & Crane Co., 20 T. C. 967; Avey Drilling Machine Co., 16 T. C. 1281.
The introduction of the Swavis garment did not represent a usual or customary event in petitioner's business. From its inception petitioner had produced only a rigid type corset. From 1926 it had produced only the Charis garment for women with problem figures. The addition of the elastic Swavis garment in 1935 for women without problem figures was an unusual innovation in petitioner's business. Petitioner's competitors had also added this type of garment, but in each case it represented an unusual event in their corporate life, as the selling of candy and popcorn was a novel, yet fairly universal, innovation in the business of theatre operators. Cf. Jefferson Amusement Co., 18 T. C. 44, 61. Also, the introduction of the Swavis line was not an addition to a varied line of products. Prior to 1935 only the Charis type garment was produced by petitioner.
It is respondent's contention that the Swavis garment was not an essentially different product, but a mere improvement on the Charis garment. He argues that the Swavis garment merely represented a more suitable substitute for that portion of petitioner's customers who purchased it. We have not found this to be the case. The Swavis garment was a new product designed primarily for an entirely different class of women from those using the Charis garment.
Recognition has been given to both the differences and the similarities between the Swavis and Charis garments and we find that the differences outweight the similarities. Cf. Stonehard Co., supra, at p. 795. The following are the principal differences between the two garments. They do not have the same consumer market as they are not suited to the same type of women. One is used to mold the figure while the other is used to smooth out the dress line. Also, they are regarded as different by both the consumer and the industry. It is true that both are foundation garments and both are made by the same machines and personnel. But the difference is not merely one of style, color or design. The Swavis garment was designed for a different purpose, was sold to a different class of customers, and for the most part was made with a basically different material. Cf. Pelton & Crane Co., supra.
Respondent has set out the following test for determining whether an alleged new product or service must be deemed to constitute a difference in the products or services furnished, in his Regulations 112, section 35.722–3( d):
(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. The president of the Corset and Brassiere Association of America testified for the petitioner. He stated that the Swavis and Charis lines ‘* * * are in a different category of garments, as we would define them in the industry.’ Considering this testimony and other evidence, in our opinion petitioner has shown that it is a trade custom or practice to treat a Swavis type garment as a product of a different class from a Charis type. Therefore the addition of the Swavis garment constituted ‘a difference in the products or services furnished.’
The facts in the instant case are similar to those in 7-Up Fort Worth Co., 8 T. C. 52. There the taxpayer was in the business of bottling a soft drink known as 7-Up. It obtained a franchise and began bottling a Nesbitt orange drink. The Nesbitt orange and 7-Up drinks were bottled with the same equipment in the same plant and were sold and delivered by the same personnel. The Nesbitt orange drink had less carbonation than 7-Up, was not especially adaptable as a ‘mixer’ for alcoholic beverages, and its chief market was in homes and among young people. It competed with 7-Up, if at all, to a very limited extent. This Court there recognized a change in the character of the business. The addition of the Swavis line in the instant case represented an equal, if not greater, difference in the products furnished.
Petitioner has demonstrated that the addition of the Swavis line brought about an essential difference or substantial change in the nature of its operations. But in order to constitute a qualifying change, the change must likewise be substantial in that as a direct result of the change the level of normal earnings of the business was increased materially over what such level would have been had the change not been made. Petitioner's gross sales of the Swavis garment were $333,925 in 1939. Since there was little, if any, competition between the Swavis and Charis lines, the addition of the new product did not cause a decrease in Charis sales and resulted in a proportionate increase in petitioner's earnings. As a direct result of the change petitioner's normal earnings were increased over what they would have been had the change not been made. It is immaterial that due to other causes petitioner's over-all earnings decreased after the change was made. The pertinent factor is that petitioner's base period earnings would have been considerably smaller than they were had the new product not been added. Cf. Jefferson Amusement Co., supra, p. 57.
Respondent does not deny that the change was made ‘immediately prior to the base period’ within the meaning of section 722(b)(4). Therefore, the addition of the Swavis line qualifies as a change under that section.
Change From Office to Home Fitting.
The shift from office fitting to home fitting does not qualify as a change in the character of the business within the purview of subsection (b)(4). Petitioner states in its brief that it ‘* * * does not contend that the change to home fittings would have increased Charis sales beyond the pre-home-fitting level * * *.’ In order to qualify for relief because of ‘a change in the operation or management of the business,’ the taxpayer must show that the change was substantial as measured by the two basic tests set out above. As was true in Central Produce Co., supra, even if we assume that the change from office to home fitting resulted in an essential difference in the nature of petitioner's operations, the second basic requirement, that there must be a higher level of earnings which is directly attributable to the change, was not satisfied.
Petitioner has not demonstrated that if the shift to home fitting had been made 2 years earlier, its earning level would have been greater by the end of the base period than it would have been had it continued office fitting.
Transfer of Company-Owned Branch Offices.
Petitioner's transfer of 8 of its retail offices to franchise distributors also does not qualify as a change within the purview of subsection (b)(4). During the base period there were 90 retail outlets for petitioner's products. At the beginning of the base period 78 were operated by franchise distributors and 12 were operated by petitioner. Petitioner discovered that it could increase its profits by transferring its company-owned outlets to franchise distributors. That is, the company-owned outlets would be operating at a loss if they paid the same price for the products sold as the franchise distributors. The franchise distributors were evidently more efficient than the managers of the company-owned outlets. Consequently, 7 company-owned outlets were transferred to franchise distributors in 1938 and 1 in 1939.
As we have previously indicated, in order for a change in the operation of the business to qualify under subsection (b)(4), the nature of the operations must be essentially different after the change from the nature of the operations prior to the change. Cf. Regs. 112, sec. 35.722–3( d). In our opinion the nature of the operation of petitioner's business was not essentially different because 86.7 per cent of its outlets were operated by franchise distributors in 1936 and 1937, while 95.6 per cent of its outlets were operated by franchise distributors at the close of the base period. Merely the ownership, not the operation of the outlets, was changed by the transfer. The transfer of eight outlets to franchise distributors did not result in a significant change in petitioner's method of distribution. Cf. A B C Brewing Corp., 20 T. C. 515, 536–7; Jefferson Amusement Co., supra.
The addition of the Swavis line qualifies as a change in the character of the business within the purview of subsection (b)(4). This, however, does not affect the determination of whether the shift from office fitting to home fitting or the transfer of eight outlets to franchise distributors also qualify as changes. In Suburban Transportation System, 14 T. C. 823, 832, we held that:
Each separate claim must of course rest on its own merits. Because an adjustment may or may not be required on one ground does not affect the taxpayer's right to an adjustment on some other ground. Thus, each unrelated change must be viewed separately in order to determine whether it qualifies as a change within the purview of subsection (b)(4). Neither the shift from office to home fitting nor the transfer of eight company-owned offices so qualifies.
Reconstruction.
Having determined that petitioner has qualified under section 722(b)(4), and having considered the corrective steps necessary in reconstructing petitioner's average base period net income, including adjustment for the qualifying factor, elimination of abnormal variations, and correction for growth or decline (Cf. E. P. C. 13, 1947–1 C. B. 83, 84; E. P. C. 42, 1949–1 C. B. 144) we have concluded that petitioner is entitled to a constructive average base period net income of $15,800 in excess of its average base period net income computed without regard to section 722.
Reviewed by the Special Division.
Decision will be entered under Rule 50.