Opinion
Docket No. 21011.
1951-06-13
CLAUSSNER HOSIERY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Ralph H. Schuette, Esq., for the petitioner. Arthur N. Mindling, Esq., J. Nelson, Anderson, Esq., and Irene F. Scott, Esq., for the respondent.
Ralph H. Schuette, Esq., for the petitioner. Arthur N. Mindling, Esq., J. Nelson, Anderson, Esq., and Irene F. Scott, Esq., for the respondent.
Petitioner is not entitled to the reconstruction of its average base period net income by reason of a change in the character of its business during such period by a difference in the products or services furnished within the purview of section 722(b)(4), I.R.C.
Petitioner seeks a refund under section 722 of the Internal Revenue Code, as amended, for the fiscal years ended January 31, 1942, 1943, and 1944, in the respective amounts of $88,704.38, $183,248.82, and $183,229.19. For the fiscal years 1942 and 1943 petitioner claimed relief under subsections (b)(1), (b)(2), and (b)(4) of section 722, as amended, and for the fiscal year 1944 under those subsections and subsection (b)(3)(A). Under each claim a right was asserted to an increase in the excess profits credit for the respective taxable year through the determination of a constructive average base period net income under section 722. Petitioner had paid excess profits taxes for the 3 taxable years in the respective amounts of $96,861.34, $398,927.93, and $417,395.53, which included deficiencies in such taxes of $8,156.96, $1,874.94, and $2,414.18 for the respective years.
Respondent denied all the above-mentioned claims. The petition herein was filed, assigning as error that the respondent had erred in determining that petitioner had failed to establish its right to relief under subsections (b)(1), (b)(3)(A), and (b)(4) of section 722. With respect to its claim for relief under section 722(b)(1), petitioner's plant, during portions of the calendar year 1937 of its base period, was closed because of a flood and a strike of its employees. It is stipulated by the parties that petitioner's excess profits net income for that calendar year, adjusted solely to eliminate from the base period years the income consequences of this flood and strike, is $76,000, in lieu of its actual excess profits net income of $8,315.08. This stipulation disposes of the assignments of error contained in subparagraphs (a) and (b) of paragraph 4 of the petitioner, relating to claim for relief under section 722(b)(1). However, such adjustment alone does not result in a constructive average base period net income in excess of petitioner's actual average base period net income computed under section 713(f) of the Internal Revenue Code.
Petitioner has stipulated that it is not entitled to any adjustment in its average base period net income because of factors enumerated in subsection (b)(2) and subsection (b)(3)(A). Petitioner has also abandoned certain of the issues set forth in its petition as the basis for relief under section 722. Only one issue is left for our consideration— the existence of the right of petitioner to a reconstruction of its base period net income under section 722(b)(4) of the Internal Revenue Code, because of a change in the character of its business consisting of a change in the products furnished during its base period.
FINDINGS OF FACT.
Petitioner is a Kentucky corporation, engaged since its organization in 1922 in the business of manufacturing and selling ladies' full fashioned hosiery. Its returns for the taxable years in question were filed with the collector of internal revenue for the district of Kentucky.
Since February 1, 1938, petitioner has kept its books and filed its Federal income and excess profits tax returns on the basis of a fiscal year ended January 31. Prior to February 1, 1938, petitioner kept its books and filed its Federal tax returns on a calendar year basis, except that it closed its books on January 31, 1938, and filed its Federal tax returns for the month of January 1938.
During the years 1938 and 1939, E. I. duPont deNemours and Co., hereinafter referred to as duPont, was the sole manufacturer of nylon yarn. In December 1938 a pilot plant for the manufacture of nylon yarn was placed in operation by duPont.
In the latter part of 1939, petitioner's sales manager called upon duPont to advise the latter of petitioner's facilities and its desire to receive nylon yarn for the manufacture of hosiery. Thereupon petitioner, with 35 other mills, was designated by duPont to receive shipments of nylon yarn. Petitioner received its first shipment of nylon yarn in October of that year, under an agreement with duPont that this yarn was to be used only for experimental purposes, and that samples of the hosiery from this yarn were to be returned to duPont for test purposes. Petitioner was not permitted, under that agreement, to put into its regular stock for sale any hosiery manufactured by it prior to March 1, 1940, out of nylon yarn received by it for experimental purposes.
During the calendar year 1939 petitioner purchased from duPont only 358.7 pounds of nylon yarn, for which it paid duPont $1,353.66.
The total sales of nylon yarn in pounds by duPont during the years 1938 and 1939 were 3,400 and 41,800, respectively. The actual production in pounds is not available, but was approximately the same as sales for each of the two years. Not all of the sales of nylon yarn by duPont during these two years were made to manufacturers of hosiery.
During the years 1938 and 1939 duPont supplied nylon yarn to manufacturers of ladies' hosiery other than petitioner, as follows:
+---+ ¦¦¦¦¦ +---+
Number of Largest poundage Smallest Yea ladies' hosiery to any one poundage to any manufacturers customer one customer supplied 1938 2 767 61 1939 35 2,480 6
Operation by duPont of its first commercial plant for the manufacture of nylon yarn started in December 1939, and commercial shipments by duPont to manufacturers of ladies' hosiery were commenced during 1940. Commercial shipments to petitioner by duPont were started February 24, 1940.
Under an agreement signed by duPont on January 10, 1940, and by petitioner on January 26, 1940, duPont granted to petitioner a nonexclusive, nonassignable, royalty-free license limited to the manufacture and sale of ladies' full fashioned hosiery, made entirely from nylon yarn, with a minimum machine gauge of 45 and with a minimum net selling price per dozen pairs of nylon hosiery, as follows:
+---+ ¦¦¦¦¦ +---+
First grade Net Irregulars Net 45 gauge $8.25 45-gauge $6.50 48-gauge 9.00 48-gauge 7.00 51-gauge and finer 9.75 51-gauge and finer 7.50
This agreement provided that each pair of nylon stockings manufactured thereunder by petitioner would be marked in language and form approved by duPont, and that duPont would be notified of the names of all brands used on nylon hosiery sold by petitioner, and the names of all purchasers of unbranded hosiery from the petitioner. By its terms, this agreement became effective May 15, 1940, and extended to and included January 31, 1941, and was to continue thereafter until terminated by either party. DuPont had an identical agreement with each other manufacturer of nylon hosiery to whom it sold yarn in 1939 or prior to May 7, 1940.
By letter dated May 7, 1940, relating to this agreement, duPont informed petitioner that it waived and canceled limitations relating to the manufacture, use, selling prices, markings, notification of the names of brands and the names of purchasers of ladies' unbranded full fashioned hosiery made from nylon yarn. By this letter petitioner was also notified that the agreement effective May 15, 1940, would terminate January 31, 1941, since it was the intention of the duPont Company as of May 7, 1940, that hosiery manufacturers who bought nylon yarn from duPont in the future would be free to use such yarn without an express or written license. By similar letter duPont canceled the same provisions with all other customers operating under the license agreements. The petitioner had no agreements other than the aforesaid agreements relating to the purchase of nylon yarn or the manufacture of hosiery therefrom. All the nylon yarn received by petitioner in 1939 and until it received its first commercial shipment of nylon yarn in February 1940 was for experimental purposes solely.
Petitioner sold no hosiery manufactured of nylon yarn during the base period nor prior to May 15, 1940, because duPont requested and petitioner agreed that no sales would be made prior to that time. DuPont would have refused to sell nylon yarn to petitioner if petitioner had not complied with that agreement.
During the base period approximately eighty per cent of the principal types of women's full fashioned hosiery produced by all manufacturers of full fashioned hosiery in the United States were made of three- and four-thread silk. Approximately ten per cent were made of five or more threads, and only about eight per cent of two-thread silk. During the base period approximately 72 per cent of the hosiery manufactured by all manufacturers of full fashioned hosiery was three- or four-thread, manufactured on 42- or 45-gauge machines.
During the base period petitioner manufactured 12 to 15 styles of full fashioned hosiery, its substantial production and the bulk of its sales being two- and three-thread 45-gauge and four-thread 42-gauge hosiery made of silk yarn. During that time it manufactured little hosiery of one- and one-and-a-half-thread silk and a limited quantity of five- six- and seven-thread service weight silk. Petitioner's production of hosiery during the base period was more sheer than the average of the hosiery industry. During the years 1936 through 1939, petitioner owned and operated four 51-gauge machines, on which it manufactured only hosiery of one- and two-thread silk, except for the manufacture for a short time of a small amount of three-thread silk. During those years most hosiery mills, including petitioner, manufactured hosiery primarily on 42- and 45-gauge machinery.
Nearly all of the women's full fashioned hose shipped by all manufacturers of full fashioned hosiery throughout the base period were made of silk, all other yarns making up only four or five per cent of the total.
The number of legger sections installed in full fashioned hosiery mills in the United States as of April 15, 1935, and May 15, 1940, and the percentage distribution by gauge on the latter date are as follows:
+---------------------------------------------------------+ ¦ ¦May 15, 1940 ¦April 15, 1935 ¦ +-------------------------+--------------+----------------¦ ¦Number of legger sections¦254,810 ¦230,102 ¦ +-------------------------+--------------+----------------¦ ¦All gauges ¦100.0% ¦ ¦ +-------------------------+--------------+----------------¦ ¦36-and 39-gauge ¦8.7% ¦ ¦ +-------------------------+--------------+----------------¦ ¦42-gauge ¦39.4% ¦ ¦ +-------------------------+--------------+----------------¦ ¦45-gauge and higher ¦43.2% ¦ ¦ +-------------------------+--------------+----------------¦ ¦Gauge not specified ¦8.7% ¦ ¦ +---------------------------------------------------------+
For all full fashioned machines installed in the United States as of May 1940, the average monthly capacity for one legger section was 17.6038 dozen pairs of hosiery, based on two shifts of 8 hours each for 22 working days per month. Throughout the base period new full fashioned knitting machines being produced were 42-, 45-, and 51-gauge machines. The production of 48-gauge was nominal and never important. By far the most popular type was the 45-gauge machine; the 42-gauge machine became less popular, while the 51-gauge became more popular over the base period. A sharp increase in 51-gauge equipment production occurred in 1939. These statistics pertain to new knitting machines then currently being manufactured.
In 1936 to 1939, inclusive, petitioner's sales were confined to department stores and specialty shops in certain portions of the United States. Petitioner's monthly net sales in dollar amounts for the years 1936, 1937, 1938, and 1939 are as follows:
+----+ ¦¦¦¦¦¦ +----+
Month 1936 1937 1938 1939 January $58,811 $69,562 $88,454 $78,431 February 91,442 82,602 117,603 117,134 March 106,300 151,392 114,627 132,717 April 95,827 126,859 102,958 106,356 May 88,369 6,701 95,440 108,403 June 160,096 8,025 151,322 150,583 July 51,962 89,735 53,431 54,072 August 112,243 138,120 119,830 122,341 September 134,280 134,376 133,630 157,294 October 169,973 148,748 128,548 162,537 November 170,780 185,106 190,427 200,098 December 103,458 88,193 81,526 92,429
The following schedule shows petitioner's net sales and net income before taxes on a yearly basis from 1923 through the fiscal year ended January 31, 1940:
+--+ ¦¦¦¦ +--+
Net income before Year Net sales taxes; () denotes loss 1923 $97,603 $1,274 1924 255,171 (19,768) 1925 395,570 39,912 1926 441,340 26,658 1927 580,637 59,151 1928 654,307 63,547 1929 699,138 44,855 1930 465,452 (57,549) 1931 684,130 (65,843) 1932 584,295 8,028 1933 701,836 46,437 1934 856,973 3,676 1935 1,345,150 59,215 1936 1,586,526 46,027 1937 1,422,342 (6,390) 1938 86,909 (4,078) F.y. 1/31/39 1,630,650 90,530 F.y. 1/31/40 1,475,054 83,961
‘Throwing‘ is the spinning or making yarn from raw silk. In each base period year petitioner reflected on its books throwing income which it sometimes included under sales and sometimes as an offset on its cost of operation. Petitioner did commission throwing and was paid by other companies for throwing silk for them. As of March 8, 1940, petitioner had not begun the throwing of nylon yarn.
During the years 1936 to 1939 the popular retail price for the big volume of business of ladies' full fashioned hosiery made of silk was 79 cents. The price range was from 59 cents to $1.15, possibly $1.25 maximum for any volume styles. Specialty numbers were higher but the volume was very limited. The first quality hosiery that petitioner made in the base period years was principally in a price range that retailed at 79 cents, 89 cents and $1. Petitioner's low end number was one which retailed for 79 cents. It had a one-thread 54-gauge number which retailed for $1.95, but the volume was insignificant.
During the base period petitioner extended discounts of 1 per cent 10 days to all customers, and 5 per cent discounts to approximately ten of its customers, as an inducement to sell petitioner's hosiery. During the base period it was also petitioner's policy to cooperate with the dealer or customer by paying 50 per cent of the cost for advertising its hose, which was the standard policy of practically every branded line. During the base period petitioner closed out certain styles of hose at a discount in addition to its cash discounts. The prices actually received by petitioner during the base period years reflected the discounts, the close-out of certain styles of hosiery and the sales of irregulars and seconds.
The net average receipts per dozen pairs of hose sold by the petitioner were $7.04 for the last six months of 1937, $6.56 for the year 1938, and $6.74 for the year 1939. The last two annual averages are based on 207,000 and 221,500 dozen pairs, respectively.
On January 1, 1936, the petitioner had in place in its plants a total of 51 legger knitting machines with 1,018 legger sections. The distribution of the equipment in place at that time as to gauge and legger sections was as follows:
+-------------------------------------+ ¦Legger knitting¦ ¦ ¦ +---------------+-----+---------------¦ ¦machines ¦Gauge¦Legger sections¦ +---------------+-----+---------------¦ ¦26 ¦42 ¦482 ¦ +---------------+-----+---------------¦ ¦14 ¦45 ¦312 ¦ +---------------+-----+---------------¦ ¦4 ¦48 ¦80 ¦ +---------------+-----+---------------¦ ¦4 ¦51 ¦96 ¦ +---------------+-----+---------------¦ ¦3 ¦54 ¦48 ¦ +---------------+-----+---------------¦ ¦51 ¦ ¦1,018 ¦ +-------------------------------------+
All of these machines were owned by the petitioner except 10 with 180 legger sections which were leased. These machines had been acquired between 1922 and 1933.
Between January 1, 1936 and December 31, 1939, there was a reduction of 16 legger knitting machines with 208 legger sections, which included 10 leggers eliminated by cancellation of their lease. At the end of 1939 the distribution of equipment as to gauge was as follows:
+----------------------+ ¦10 leggers of 42 gauge¦ +----------------------¦ ¦21 leggers of 45 gauge¦ +----------------------¦ ¦4 leggers of 51 gauge ¦ +----------------------+
The petitioner operated, on a single shift of 8 hours, only one 51-gauge legger knitting machine in its experimental manufacture of hosiery with nylon yarn, to and including December 31, 1939. This 51-gauge machine was one petitioner had been using throughout the base period in the manufacture of hosiery from silk yarn. The same knitting machines could be used in the manufacture of hosiery from nylon yarn as were used in the manufacture of hosiery from silk yarn.
In the experimental stages, and for a long time after commercial shipments commenced, the only nylon yarn available to petitioner for use as leg yarn was 30-denier. During 1939 and prior thereto, no nylon yarn of a finer denier than 30 was manufactured by duPont. At the end of 1940 duPont was experimenting with 15-denier nylon yarn, but petitioner did not manufacture any hosiery of 15-denier nylon yarn prior to 1945.
The most durable stocking that could be made with nylon yarn was a 30-denier, 51-gauge, although it had little elasticity. The better stocking of 30-denier nylon yarn was made on a 45-gauge knitting machine since, although a little sheerness would be lost, the result was not only durability but proper elasticity and fit. Hosiery made of 30-denier nylon yarn is of about the same sheerness as that made of two-thread silk. A pair of hose made of nylon yarn would outwear at least two pairs of hose made of silk yarn of comparable denier and quality.
The basic equipment in the manufacture of hosiery is the knitting machine, which represents the big investment of hosiery manufacturers. In that industry there were relatively few changes in style in this equipment during the pertinent period. The most recent change in the knitting machine proper was in the late 30's, which permitted a stocking to be made entirely on one machine. A modern mill is one that purchases the new machinery and attachments as they are developed.
The size of hosiery manufactured out of nylon yarn is dependent on the way it is knit and on the preboarding or shrinking operation. The preboarding machine is essential to the manufacture of hosiery out of nylon yarn. The first preboarding equipment which petitioner had and used in the experimental manufacture of hosiery out of nylon yarn was designed and built by Robert E. Claussner, general superintendent of petitioner. This preboarding machine functioned fairly well and was built for experimental purposes. It was the equipment petitioner used in the base period and was capable of shaping two or three dozen pairs of hose per day. The first preboarding equipment which petitioner purchased and capitalized was in 1941.
Air conditioning is practically a necessity in the manufacture of hosiery from nylon yarn. Without it the results are inferior quality hose, a high percentage of spoils, seconds, and irregulars, large loss of production, and breakage of certain parts of the machine. petitioner began to air condition the plant in 1941 but was unable to complete it until some time after the war was over. Air conditioning equipment was installed by petitioner in the throwing and hosiery departments after the war was over as quickly as it could be secured. Similar installations were made also by various other mills at that time.
To and including December 31, 1939, the only experimental hosiery made of nylon which petitioner submitted to duPont for tests were 17 1/4 dozen pairs and 20 dozen pairs covered by invoices dated December 13 and December 21, 1939, respectively, all of which were rejected by duPont and returned to petitioner. No other hosiery was submitted by petitioner to duPont prior to the end of petitioner's base period, January 31, 1940.
During the base period considerable expansion had taken place in the full fashioned hosiery industry, particularly in the South. There was keen competition in the industry. This competition existed also between the manufacturers of seamless and full fashioned hosiery. The supply of full fashioned hosiery exceeded the demand during the base period years. The hosiery manufactured from nylon yarn had no effect upon this competitive situation during the base period, since it was not commercially available prior to 1940.
OPINION.
LEECH, Judge:
Petitioner contends that it is entitled to refunds for the years here in question based upon a reconstruction of its actual average base period net income. It claims such relief on the ground of a change in the character of its business during that period consisting of a difference in products furnished, within the purview of section 722(b)(4) of the Internal Revenue Code.
SEC. 722. GENERAL RELIEF.— CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.(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 averagebase period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the purpose of this subparagraph, the term ‘change in the character of the business‘ includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, a difference in the ratio of nonborrowed capital to total capital, and the acquisition before January 1, 1940, of all or part of the assets of a competitor, with the result that the competition of such competitor was eliminated or diminished. Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, or
Petitioner, during the base period and for many years prior thereto, was a manufacturer of full fashioned silk hosiery. It argues that in 1939 it changed from the manufacture of hosiery from silk yarn to manufacture from nylon yarn, that the character of such change was substantial, necessitating various changes in its knitting and finishing operations together with changes in its equipment, and that nylon hose, its product after the change, was entirely different in character from silk hose formerly produced and marketed.
The record establishes that before nylon became available in commercial quantities, which was subsequent to the close of the base period, silk had been ‘frozen‘ and was no longer available, and that for a considerable period petitioner was making hosiery from rayon and cotton. Such hosiery was never in competition with silk hosiery during its manufacture or with nylon hosiery after nylon yarn became available to hosiery mills for commercial use.
For petitioner to sustain its claim for relief under section 722(b)(4), it is essential that it establish (a) that there was a change in the character of its business by a change in the nature of its product furnished, and (b) that such change occurred prior to the close of its base period. Both of these conditions must be met. Even if it were concluded upon this record that a change in manufacture of full fashioned hosiery from the use of silk yarn to nylon yarn was a change in the product furnished within the purview of section 722(b)(4), petitioner, would not, in our opinion, be entitled to the relief sought, as we think the record clearly demonstrates the fact that this change did not occur during petitioner's base period, nor that petitioner was committed to such change within that period.
The record shows that petitioner did not manufacture for sale to its customers any hosiery of nylon yarn prior to the close of its base period. Prior to that time, the only use of such yarn by petitioner was for experimental purposes, with small quantities furnished by duPont which the latter produced at a pilot plant put in operation only shortly prior thereto. The limited quantities of nylon produced at this plant by duPont had been allocated to various manufacturers of silk hosiery, including petitioner, for experimental use to determine the quality of hose it was possible to produce from nylon. The only such hose knitted by petitioner in 1939 were a few dozen pairs made for experimental purposes, which, under its contract with duPont, could not be sold to the public but had to be delivered to duPont for testing purposes. These hose were rejected by duPont and returned to petitioner as not acceptable.
Our conclusion is that petitioner has not established that it is entitled to reconstruction of its average base period net income by application of section 722(b)(4). Its claim for relief under that section is accordingly denied.
Reviewed by the Special Division.
Decision will be entered for the respondent.