19 T.C. 605">*605 The Commissioner denied applications for relief under section 722 (b) (1), (b) (2), and (b) (4), I. R. C., for the fiscal years ended June 30, 1944, 1945, and 1946. The issue is whether he erred in such action and, if so, whether petitioner is entitled to the unused excess profits credit carry-over from the years 1941 and 1942. A minor issue is whether an architect's fee is an abnormal deduction for the year ended June 30, 1939.

Applications for relief under section 722 for the taxable years ended June 30, 1944, 1945, and 1946, were duly filed by petitioner on May 6, 1947, March 8, 1948, and December 23, 1948, respectively, and were denied by the respondent.

FINDINGS OF FACT.

Some of the facts are stipulated and are so found.

The petitioner is an Ohio corporation engaged in lithographing labels. It filed its tax returns for the years before us with the collector of internal revenue for the first district of Ohio.

Petitioner's plant is located in Cincinnati, Ohio, but its products are sold throughout the country. While the petitioner manufactures products for the brewing, liquor, and food industries, the brewing industry is the dominant industry served by petitioner. 1952 U.S. Tax Ct. LEXIS 3">*5 About 50 per cent of petitioner's business is devoted to the production of beer labels.

The petitioner's manufacturing process is distributed among three major departments: the plate-making department, the press department, and the cutting-finishing department. In the plate-making department, the label design, which is submitted by the customer or 19 T.C. 605">*606 prepared for him, is impressed, in multiple form, on a zinc press plate. The plate is then attached to the printing press machine. The press department operates the printing press machines wherein the label designs are lithographed or printed on large sheets of paper. Sometimes several hundred labels are printed on one sheet of paper. In the cutting-finishing department, the sheets of labels, which are produced in the press department, are cut into the various finished forms, sizes and shapes.

Prior to 1939, petitioner employed the hand-transfer process for making its zinc press plates. The hand-transfer process was a slow and laborious process; all operations were performed by hand. The main steps in the preparation of zinc plates under the hand-transfer process are: (1) the preparation of the stones ¹ by the stone-planer1952 U.S. Tax Ct. LEXIS 3">*6 who planes the stone level with a planing machine and then manually rubs the stone smooth with pumice and a rubbing stone; (2) the engraving of the label design on the "original stone" by the stone-engraver; (3) the transfer of the engraving to the "transfer stone" by means of making a proof from the "original stone" on transfer-paper and the preparation of a separate impression for each color; (4) the retouching of the transfer-stone by the stone-engraver to correct flaws and perfect the design; (5) the preparation of the key-sheet by means of multiple impressions pulled from the transfer stone and the transfer of the multiple designs on the key-sheet to a zinc plate for use in preparing the keyboard; and (6) the preparation of a zinc plate for each color after "sticking" the color impressions on the keyboard.

The hand-transfer process1952 U.S. Tax Ct. LEXIS 3">*7 required the services of a stone-planer who prepared the stones for the engravings, four or five stone-engravers who etched the designs onto the stones, and eleven to fourteen transferors who pulled (made proofs) impressions from the stones for the preparation of the zinc press plates.

In October 1938, after an investigation of photo-mechanical platemaking equipment, petitioner ordered a photo-composing machine with necessary accessories at an aggregate cost of $ 13,248.49. This equipment was installed and ready for operation on or about March 1, 1939.

During the latter part of 1938 and the early part of 1939, petitioner also purchased three offset presses for $ 86,420.62, trading in four of its old offset presses and receiving therefor an allowance of $ 27,500. The old presses handled paper sheets of a size 38 x 52 inches, whereas the new presses handled sheets of a size 42 x 58 inches. The new presses could print 5,000 sheets per hour as compared to 4,000 sheets per hour for the old presses.

19 T.C. 605">*607 The etching of engravings on the Bavarian stones and the pulling of impressions from such stones on the transfer-paper which were essential elements in the hand-transfer method 1952 U.S. Tax Ct. LEXIS 3">*8 of producing press plates are eliminated under the photo-mechanical method. The latter process of producing press plates is, in contrast to the hand-transfer method, a speedy and mechanical process capable of producing labels superior in quality to those produced under the hand-transfer method. Under the photo-mechanical process the zinc press plates are prepared from photographic film. No hand work is required except in one step of the process when a blueprint is filled in by a photo-artist with pen and black ink. All other steps are performed by photography. In the final step a chemically prepared zinc plate is exposed to light through a negative film. The zinc plate is then developed and is ready for the actual lithographing work on the press.

The preparation of press plates under the photo-mechanical process required one-third of the time that was required for the same job under the hand-transfer process. The photo-mechanical process eliminated the need of the stone-planer, the stone-engravers, and the transferors required in the hand process. In the photo-mechanical process, two photo-artists replaced the engravers, and two photo-composing machine operators were added. 1952 U.S. Tax Ct. LEXIS 3">*9 The hand-transfer process required about twice as many men as did the photo-mechanical process for the completion of the same type of job.

However, the installation of the new equipment and the introduction of the photo-mechanical process created practical operating difficulties for the petitioner. The old employees were fearful of losing their jobs and did not completely cooperate with petitioner in manufacturing the labels. Shipments were delayed; the quality of petitioner's production and the volume of output deteriorated. Because of these transition difficulties, petitioner lost label business to other firms. Petitioner's net sales to all of its customers dropped from $ 338,785.76 during the calendar year 1938 to $ 258,532.16 during the calendar year 1939. Despite these circumstances, petitioner was compelled to retain many of its employees in the plate-making department so that it could revert to the hand-transfer process of filling its orders when production under the new method failed. By the early part of 1942 the new process was working smoothly. Under normal conditions the photo-mechanical system would have operated effectively at petitioner's plant 3 months after1952 U.S. Tax Ct. LEXIS 3">*10 its installation.

The number of artists, engravers, stone-planers and transferors, and photo-mechanical equipment operators, in the employ of the petitioner in its plate-making department was as follows: 19 T.C. 605">*608

The petitioner was in existence during the entire base period and kept its books and reported its income on the accrual method of accounting. When it used the manual process the petitioner's direct labor expenses in the plate-making department for the 12 months preceding December 31, 1938, were approximately $ 33,000. The direct labor expense for a complete crew in this department when the photo-mechanical1952 U.S. Tax Ct. LEXIS 3">*11 equipment was operating was approximately $ 20,000. The quantity of production was the same for both operations.

A record of petitioner's net sales for a decade is as follows:

Petitioner is entitled to use the excess profits credit based on income under the provisions of section 713 of the Code. The excess profits credit for the taxable years here involved, without application of section 722, was:

The petitioner's excess profits net income, as determined for the foregoing taxable years, was: 19 T.C. 605">*609

1952 U.S. Tax Ct. LEXIS 3">*12 The petitioner's actual excess profits net income or loss for each of the base period years, as finally determined for the purpose of computing its excess profits taxes for the years ended June 30, 1944, 1945, and 1946, under the provisions of section 711 (b) but without the application of section 722, was:

During the year ended June 30, 1937, petitioner incurred abnormal flood loss expenses of $ 9,262.57, and flood loss repairs of $ 461.79. During the year ended June 30, 1938, petitioner suffered a capital loss of $ 68.

Petitioner requested an architect to draw plans to erect a building for $ 25,000. The plans were abandoned because the bids for the construction work were almost twice the costs which the architect had estimated. The architect's fee was compromised for $ 1,000.

The installation of the photo-mechanical equipment by the petitioner was a change in the character of its business within the meaning of section 722 (b) (4).

Petitioner's income by December 31, 1939, did not reach the level of the earnings it would have reached if the 1952 U.S. Tax Ct. LEXIS 3">*13 new equipment had been installed 2 years earlier. Petitioner's average base period net income computed without the benefit of section 722 is an inadequate standard of normal earnings. The sum of $ 30,422 ² is a fair and just amount representing normal earnings to be used by the petitioner as constructive average base period net income for the purpose of computing its excess profits tax for the taxable years ended June 30, 1944, 1945, and 1946. In determining the unused excess profits credit carry-over from the year ended June 30, 1942, the constructive average base period net income shall be $ 22,840 for the year ended June 30, 1942.

19 T.C. 605">*610 OPINION.

Petitioner alleges that under section 722 (b) (4) the character of its business was changed by a change in the operation of its business. The change in operation involved the installation1952 U.S. Tax Ct. LEXIS 3">*14 of photo-mechanical equipment to produce zinc press plates, thereby eliminating the hand-transfer process for making these plates. Petitioner contends that operating economies were achieved by the installation of this new equipment, and that reduction in costs increased the income, thus entitling it to relief under section 722 (b) (4). Petitioner claims that its actual average base period net income is an inadequate standard of normal earnings because its entire base period did not reflect the operating economies resulting from the installation of new equipment.

Section 722 (b) (4) provides that the excess profits tax shall be considered 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 * * * the taxpayer, * * * during * * * the base period, * * * changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business." It further provided that "the term 'change in the character of the business' includes a change in the1952 U.S. Tax Ct. LEXIS 3">*15 operation * * * of the business."

It is conceded that petitioner is entitled to use the excess profits credit based on income pursuant to section 713. In accordance with orderly procedure we shall first consider whether there was a change in the operation of petitioner's business.

In October 1938 petitioner ordered a photo-composing machine with its necessary equipment and accessories at an aggregate cost of $ 13,248.49. This equipment was installed and ready for operation on or about March 1, 1939. The new equipment enabled petitioner to make zinc press plates by a mechanical means, and thus eliminate the manual processing of these plates. The preparation of the press plates under the photo-mechanical process required less than one-third of the time necessary under the hand-transfer process. The photo-mechanical process required about half the labor force that was utilized in the hand-transfer process. The more rapid production of the press plates, coupled with the reduction of the labor force, resulted in substantial operating economies. Furthermore, with this new equipment it was possible to produce a product superior to that produced by the hand-transfer method.

The regulations1952 U.S. Tax Ct. LEXIS 3">*16 provide that a similar change would be within the scope and intent of the Code.

19 T.C. 605">*611 * * * In 1937 Corporation B engaged in coal mining converted from a system of hand loading, under which it had lost money, to a mechanized loading which reduced operating costs and resulted in profits; a change in operations has occurred. * * * [Regulations 112, section 35.722-3 (d)].

We have also held in other situations that a change in the method of purchasing brandy, Beringer Bros., Inc., 18 T.C. 615, the change of a radio station antenna, Southland Industries, Inc., 17 T.C. 1551, and a change in business contracts, Packer Publishing Co., 17 T.C. 882, to name a few, were changes in the operation of a business and within section 722 (b) (4).

When we see the accelerated production, the reduced labor force, and the improved product, we must conclude that a change in the operation of the business has occurred. We find that such a change -- the installation of the photo-mechanical equipment -- is within the contemplation of section 722 (b) (4).

As an adjunct to the new photo-mechanical equipment petitioner1952 U.S. Tax Ct. LEXIS 3">*17 also replaced four old offset presses with three new presses. This replacement is not a change in the operation of the business but rather an ordinary, usual and routine improvement which can not form the basis for relief. See Suburban Transportation System, 14 T.C. 823, 833. The new presses performed the same service as the old ones. While there is evidence that each individual new press had a greater capacity than the old ones, it appears that the aggregate production of the three new presses equaled the production of the old presses. The petitioner has not shown an increase in production based upon the installation of the new presses. Therefore, this installation of new presses does not qualify as a change in the character of the business.

Recognizing that the new photo-mechanical equipment was a change in the character of the business, we must next determine whether this change was reflected by an increase in petitioner's earning capacity so as to render its average base period net income an inadequate standard of normal earnings for the entire base period. Section 722 (b) (4). An increase in earning capacity may result not only from increased1952 U.S. Tax Ct. LEXIS 3">*18 sales or production, but also from a decrease in operating expenses.

This is the situation we have before us. On December 31, 1938, in the time immediately prior to the installation of the new equipment, the petitioner had 20 employees in the plate-making department. On December 31, 1941, about the time the operation was running smoothly, petitioner's labor force was reduced to 12 employees in this department. Still later there were only 7 people in this same department. The facts show that the photo-mechanical equipment made it possible for petitioner to reduce its labor force in the plate-making department.

The next logical step is to question whether this reduced labor force decreased the direct labor expenses. Using the manual process, the direct labor expenses in the plate-making department for the 12 19 T.C. 605">*612 months preceding December 31, 1938, were approximately $ 33,000. The direct labor expense for a complete crew in this department when the photo-mechanical equipment was operating was approximately $ 20,000. The quantity of production was the same for both operations. However, under the mechanical method less time was required, and a better label was produced. 1952 U.S. Tax Ct. LEXIS 3">*19 We think that it is proper to conclude that this savings in labor costs under normal conditions would result in a reduction of operating expenses and an increase in earning capacity, after allowing for reasonable depreciation of the new equipment. Petitioner's average base period net income was an inadequate standard of normal earnings for the base period.

The new equipment was ready for operation on or about March 1, 1939. Uncontroverted expert testimony was introduced which was evidence of the fact that, generally, normal production would have been attained 3 months after the installation of the photo-mechanical equipment. However, the transition from the old to the new method took much longer than 3 months. Petitioner contends that the extended transition time was the result of labor difficulties. Respondent contends that the delay was caused by inefficient management. The evidence indicates that the old employees were fearful that the new equipment would eliminate their jobs. The employees' fears resulted in a work slow-down. Nevertheless, they were not discharged for their lack of cooperation since petitioner required their services, skill, and experience to maintain production1952 U.S. Tax Ct. LEXIS 3">*20 with the old method when production under the new method failed. During this transition period the quality of petitioner's production deteriorated with a resulting decrease in sales. Considering the extended transition time and the decreased sales, we find that petitioner did not reach by the end of the base period the earning level which would have been reached if petitioner had made the change 2 years earlier. We believe that the labor problems would have been the same even under the push-back rule. Thus, the benefits of the push-back rule are available to the petitioner.

On the entire record we hold that petitioner has established that there was a change in the operation of the business, that the change resulted in an increased earning capacity, that the tax computed without the benefit of section 722 resulted in an excessive and discriminatory tax, and that its average base period net income is an inadequate standard of normal earnings. To further qualify for relief petitioner must show what is a fair and just amount representing normal earnings to be used as the constructive average base period net income.

The respondent agrees that the petitioner is entitled to the flood1952 U.S. Tax Ct. LEXIS 3">*21 loss adjustment for the year ended June 30, 1937, and to the capital loss adjustment for the year ended June 30, 1938. The petitioner claims in addition that it is entitled to treat the architect's fee as an abnormal 19 T.C. 605">*613 deduction, but the Commissioner disagrees. Issues relating to abnormal deductions arise under section 711 (b) (1) rather than under section 722, but if the question of the architect's fee is properly before the Court at this time, nevertheless, the petitioner must lose because it has failed to sustain its burden of proof. Its argument and showing is merely that it did not continue with the building plans and that is not sufficient.

Because the petitioner's last base period year ended 6 months subsequent to December 31, 1939, it is necessary to reconstruct its income for the 6 months ended June 30, 1940.

From the record of petitioner's earnings, we conclude that its earnings for the last half of its fiscal year ended June 30, 1940, will be nearly equal to those for the first half of the year. Cf. East Texas Motor Freight Lines, 7 T.C. 579, 596.

Petitioner has introduced sufficient evidence to establish a fair and just amount1952 U.S. Tax Ct. LEXIS 3">*22 representing normal earnings to be used as a constructive average base period net income. It is proper for us to reconstruct what is a reasonable amount of relief if this can be done from the record. Jefferson Amusement Co., 18 T.C. 44; Victory Glass, Inc., 17 T.C. 381, 388. We have determined the constructive average base period net income to be $ 30,422.

Since we have decided that petitioner is entitled to a constructive average base period net income, we must decide whether petitioner is entitled to an unused excess profits credit carry-over from the years ended June 30, 1941 and 1942.

No carry-over to the years in controversy ³ may be obtained for the year ended June 30, 1941, since 2 years is the limit of the carry-over. Section 710 (c). Further, no carry-over for the year ended June 30, 1941, may be carried over to the year ended June 30, 1943, because petitioner has failed to make a formal claim as prescribed in the regulations. See section 35.722-5, Regulations 112; Lockhart Creamery, 17 T.C. 1123.

1952 U.S. Tax Ct. LEXIS 3">*23 However, when we come to the carry-over for the year ended June 30, 1942, more favorable treatment is required if a carry-over for that year turns out to be warranted under the Rule 50 recomputation. For the year ended June 30, 1944, petitioner made a proper and timely application for relief under section 722. Included in this application (Form 991) petitioner submitted a "Redetermination of Unused Excess Profits Credit Carry-over," and based on its own reconstruction of average base period net income, it computed an unused excess profits credit adjustment from the year 1942. Contrary to the respondent's contention, there was a proper claim for the benefits of a credit arising 19 T.C. 605">*614 from the use of a constructive average base period net income for the year ended June 30, 1942. See Packer-Publishing Co., supra, p. 898.

Respondent has urged on brief that the "variable credit rule" ⁴ be used in computing a constructive average base period net income for the years ended June 30, 1941 and 1942.

1952 U.S. Tax Ct. LEXIS 3">*24 We quote from the Bulletin on Section 722 of the Code, p. 120, as to the respondent's explanation for the need of the rule:

* * * If the business which has been commenced or changed has reached its full level of normal operations during the excess profits tax taxable years, the standard so obtained is a fair measure of normal profits. However, there are instances in which the business may not have reached its full level of normal operations during the excess profits tax taxable years. In such situations it would obviously be unfair to allow the use of a "yardstick", based on full level of normal operations, for the measurement of earnings based on operations which have not reached that level. The regulations provide in such cases for the determination of a fair and just amount representing normal earnings which amount may vary in different excess profits tax taxable years. * * *

The Bulletin refers to section 35.722-3 (d) of Regulations 112 for the authority for this rule. This section is in part as follows:

Since the amount of normal earnings in the case of a taxpayer which is considered to have commenced business or changed the character of its business two years prior to the1952 U.S. Tax Ct. LEXIS 3">*25 actual event is based upon a reconstructed business experience which has been lengthened two years, such amount may exceed the actual earnings realized by the taxpayer during its first or second excess profits tax taxable year. Consequently, the reconstruction normal earnings which would be used as the constructive average base period net income after the second excess profits tax taxable year may not constitute a fair and just amount to be used for the purposes of the excess profits tax for the first or second excess profits tax taxable year. Therefore, in determining the constructive average base period net income to be used in computing the excess profits tax or the unused excess profits credit for the first or second excess profits tax taxable year, the fair and just amount representing normal earnings should be based upon the actual earning capacity which, as of the end of its base period, the taxpayer could reasonably have been expected to reach under normal conditions during such first or second excess profits tax taxable year. * * *

In other words, the variable credit "rule," as stated above, may be considered when the last year of the base period reflects substantially1952 U.S. Tax Ct. LEXIS 3">*26 less than a full level of normal operation, and after the application of the 2-year push-back rule the question arises whether earnings had reached a normal level during the first and second excess profits tax taxable years. The rule provides that earnings during these 2 years of growth should not be reduced by an excess profits credit based upon a normal earning capacity. Failure to apply the variable credit 19 T.C. 605">*615 "rule" in a situation such as we have here would result in a double benefit to the petitioner, and such was not intended by section 722.

From the evidence we have found that the new process was working smoothly by the early part of 1942, therefore, development was still in process in 1940 and 1941, and the first part of 1942. The variable credit rule is intended to apply in such a situation. Petitioner is not entitled to an operating loss carry-over from 1941, but since we have determined, if the Rule 50 computation warrants it, the propriety of a carry-over from 1942, we must determine a constructive average base period net income to be used for the 1942 computations. We have found this constructive average base period net income for 1942 to be $ 22,840.

Petitioner1952 U.S. Tax Ct. LEXIS 3">*27 has also claimed relief under section 722 (b) (1) and (b) (2). Its basis under section 722 (b) (1) is that the employees' resistance to the new method was tantamount to a sit-down strike and thus was an event "unusual and peculiar" in its experience. Petitioner also alleges that the resulting loss in sales was a "temporary economic" event within the scope of section 722 (b) (2). Petitioner seeks relief under these two subsections only in the event relief under section 722 (b) (4) is denied. Since we have found a constructive average base period net income under section 722 (b) (4) for normal operating conditions, we do not need to discuss petitioner's other allegations.

Reviewed by the Special Division.

Decision will be entered under Rule 50.