21 T.C. 252">*252 Waldorf System, Inc., is the parent corporation of an affiliated group and will herein be referred to as the petitioner.

The respondent determined deficiencies and overassessments in the income and excess profits tax liabilities of the petitioner and its affiliated1953 U.S. Tax Ct. LEXIS 28">*29 corporations for the calendar years and in the amounts as follows:

In connection with the foregoing determinations, the respondent rejected claims for relief from excess profits tax liability filed by the petitioner under Code section 722 and gave formal notice of such disallowance.

As to the deficiencies, the petitioner alleges error in the determination on the ground that the amounts set forth were paid to the collector before the issuance of the notice. Facts have been stipulated which establish the dates and amounts of assessments and payments made. If any decision need be made on this issue, it can be made under Rule 50 on the basis of the stipulated figures.

The petitions allege error in the respondent's failure to allow relief under the provisions of Code section 722, subsection (b) (3) (A) on the ground of the existence of a variant profits cycle, and subsection (b) (4) on1953 U.S. Tax Ct. LEXIS 28">*30 the ground of a change in the character of the petitioner's business. The parties have stipulated that the petitioner has established 21 T.C. 252">*253 its right to reconstruct normal earnings under section 722 (b) (4) and that the result thereof is that the petitioner is entitled to additional constructive average base period net income in the amount of $ 75,000. This allowance affords no relief to the petitioner as the excess profits credit based on such increased income is less than the credit computed on invested capital.

The applications for relief and claims filed are for the refund of excess profits taxes for years and amounts as follows:

In addition to the claims for relief for the taxable years based on constructive average base period net income for those years, the petitioner alleges that it is entitled also to reconstruct for the year 1940 which would give it an unused excess profits credit carry-over from 1940 to 1941.

Summarizing the above, the issue to be decided is whether or not the petitioner is entitled to relief from excess profits taxes1953 U.S. Tax Ct. LEXIS 28">*31 under the provisions of Code section 722, subsections (a) and (b) (3) (A). No claim for relief is made on behalf of the petitioner's subsidiaries.

The proceeding was heard before Raymond J. Bowen as a Commissioner designated for that purpose pursuant to Rule 48 of the Rules of Practice before The Tax Court and section 1114 (b) of the Internal Revenue Code. Objections filed by the parties to the report of the Commissioner have been carefully considered. The findings of fact herein are substantially as found by the report of the Commissioner.

FINDINGS OF FACT.

I. General Facts.

For all years pertinent hereto, the petitioner and its affiliated corporations maintained their books and records in accordance with the accrual method of accounting, and for the excess profits tax years involved in these proceedings they filed consolidated Federal excess profits tax returns on a calendar year basis in accordance with that method of accounting. The consolidated returns were filed in the name of Waldorf System, Incorporated, as the common parent.

The excess profits net income (or loss) of each of the affiliated corporations, and of the consolidated group, for the base period years 19361953 U.S. Tax Ct. LEXIS 28">*32 to 1939 was as follows: 21 T.C. 252">*254

As computed under the provisions of section 713 (e) of the Internal Revenue Code, the average base period net income of the consolidated group was $ 475,599.30.

The excess profits tax credits of the consolidated group for the taxable years, computed under the invested capital method provided by Internal Revenue Code section 714, were as follows:

The amounts of excess profits net income of the1953 U.S. Tax Ct. LEXIS 28">*33 several corporations and consolidated excess profits net income, computed under the invested capital method, for the years 1940 to 1945 were as follows:

The amounts of excess profits net income shown above for the year 1940 are after deduction of Federal income taxes. Prior to such deduction, the amounts of such income would be as follows:

The petitioner, Waldorf System, Inc., is a corporation organized on April 18, 1919, under1953 U.S. Tax Ct. LEXIS 28">*34 the laws of Massachusetts, with its principal office and place of business at 169 High Street, Boston, Massachusetts.

The consolidated excess profits tax returns for the taxable years were filed with the collector of internal revenue for the district of Massachusetts. The returns were filed by the petitioner on behalf of 21 T.C. 252">*255 itself and for its wholly owned subsidiaries, namely, The Clark Restaurant Company, the Ginter Restaurant Company, St. Clairs', Inc., and the Fort Hill Supply Company.

The petitioner is both a holding corporation and an operating corporation. From the time of its incorporation through the taxable years, it operated a chain of cafeterias (hereinafter referred to as the Waldorf Division), in addition to owning the entire stock of its four affiliated corporations from the dates of acquisition thereof as shown below.

II. Facts as to Affiliated Corporations.

The Clark Restaurant Company was incorporated under the laws of Ohio in 1919. Its entire capital stock was acquired by the petitioner on or about January 1, 1922. The restaurants ¹ operated by it (hereinafter referred to as the Clark Division) are operated under the name of "Clark's" and consist 1953 U.S. Tax Ct. LEXIS 28">*35 of combination counter and waitress-table service. All of the restaurants of Clark Division were located in Ohio with the exception of one located at Erie, Pennsylvania.

The Ginter Restaurant Company was incorporated under the laws of Massachusetts in January 1927, and at that time its entire capital stock was acquired by the petitioner. The restaurants operated by it (hereinafter referred to as Ginter Division), were of the waitress-table type except one which had only counter service with some incidental over-the-counter bakery sales. All of the restaurants operated by Ginter Division were located in Boston, Massachusetts.

St. Clairs', Inc., was incorporated in 1907 under the laws of Massachusetts, and its entire capital stock was acquired by the petitioner on or about July 1, 1929. The restaurants1953 U.S. Tax Ct. LEXIS 28">*36 operated by it (hereinafter referred to as the St. Clair Division) were of the table and counter type served by waitresses. All of the restaurants operated by the St. Clair Division were located in Massachusetts.

Fort Hill Supply Company (hereinafter referred to as Fort Hill) is a Massachusetts corporation organized on March 7, 1927, by the petitioner which then acquired all of its capital stock. It was organized for the purpose of operating as a wholesale jobber of restaurant equipment. Its principal customers are the above mentioned Waldorf, Clark, Ginter, and St. Clair Divisions of the petitioner.

III. Extent and Method of Operations of Waldorf Division.

General Facts.

During the period covered by the years 1922 to 1939, Waldorf Division operated cafeterias in the States of New York, Massachusetts, 21 T.C. 252">*256 Connecticut, and Rhode Island. The number of restaurants operated by it and its affiliated operating corporations at the close of each year was as follows:

1953 U.S. Tax Ct. LEXIS 28">*37 The restaurants operated by Waldorf Division were of the cafeteria type. They differed from the usual cafeteria in that there was no rail in front of the counter and steam table from which food was served. Customers could approach directly that part of the service counter which contained the articles of food they desired and did not need to get in a line. Upon being served at the counter, the customers carried the food to tables where it was consumed.

Restaurants and cafeterias that are members of chains customarily carry some sign that identifies them as being a part of a particular chain. In the case of Waldorf Division, the identifying sign was a big red apple bearing the name "Waldorf." Food prices in chain restaurants are generally low in relation to prices in other types of restaurants.

The pattern of operations of Waldorf Division was generally the same in the base period and for many years prior thereto. All operations were directed from the petitioner's headquarters at 169 High Street, Boston, Massachusetts. At those headquarters, control was maintained over purchases of provisions and equipment, personnel, medical services, and leasing and real estate operations. 1953 U.S. Tax Ct. LEXIS 28">*38 Accounting and financial operations were centered in the Boston headquarters. The claims department was located there. The Boston headquarters made up all menus, weekly, for all of the Waldorf Division cafeterias. It made up recipes and tested them before sending them out to the operating divisions. There were maintained and operated at headquarters a laundry and central commissary and bakery. A great deal of the jams, jellies, and tomato juice used by the cafeterias was prepared at the headquarters commissary. Each major operation at headquarters was under the direction of a manager who was a well-paid expert.

21 T.C. 252">*257 The petitioner's management in the Boston headquarters maintained close control and supervision of the purchases of provisions. As to large quantity purchases, decisions were made as the result of joint consideration by the petitioner's president, general manager, and the head of the purchasing department. The cost of provisions was of critical importance in the petitioner's business and commodity prices were watched closely. In making purchases, management first determined the quantity of a given commodity that would be required by its restaurants over a 1953 U.S. Tax Ct. LEXIS 28">*39 period of months. It attempted to determine the future market prospects of that commodity. If it appeared that there was a possibility of a rise in price, purchases were made of a sufficient quantity to last for a period of at least 9 months. Constant checking of markets often disclosed weak spots due to an over-supply in the hands of a producer or distributor. This situation would enable the petitioner to buy at a price below the market, and in such cases it would purchase large quantities. Commodity prices in different cities were watched, and advantage was taken of any differential in prices by purchasing in the lower priced market. If prices were lower in New York than in Boston, the petitioner's management would buy in New York and ship the merchandise to Boston in large vans that were rented on a favorable round-trip rental basis.

It was the practice of the petitioner's management to purchase a large part of its provisions directly from producers. By so doing it eliminated the jobber and his profit. If the producers offered a commodity at a favorable price, the petitioner would purchase a large quantity. It would sometimes buy as much as 10 carloads of turkeys. At one1953 U.S. Tax Ct. LEXIS 28">*40 time, on a favorable price offer, it purchased 14 carloads of pork loins. Seafood was purchased at the docks. One factor that enabled the petitioner to obtain the advantage of low prices was that it carried a sufficiently large cash balance so that it was able to, and did, pay cash on the delivery of supplies.

Waldorf Division management set up detailed, written standards or specifications covering practically every item of food purchased. For example, it was specified that pork loins must be not lighter than 8 pounds nor heavier than 12, and that turkeys must weigh between 22 and 24 pounds. The written specifications were sent to suppliers who were required to meet them on all commodities that they sold to Waldorf Division.

Menus were made up each week in conferences among the president, the treasurer, and heads of the purchasing and commissary departments. The petitioner had cost figures on all of its provisions, and the menus were prepared with a view to selling the provisions on hand that had been purchased at comparatively low prices, or such provisions as were then on the market at low prices. The menus usually carried 10 or 12 standard items in addition to pastries. 1953 U.S. Tax Ct. LEXIS 28">*41 The menus 21 T.C. 252">*258 were posted in the cafeterias and customers were supplied only with the items so shown, except that short orders would be filled.

If a new recipe proved satisfactory after testing at Boston headquarters, the recipe was sent out to the division commissaries for use in the preparation of food for the individual cafeterias.

The management in Boston maintained a strict policy with respect to quantity and portions of food served in the cafeterias. When weekly menus were sent out, the size of the individual order was specified as to every item. The quantity of the ingredients that went into pastries was specified by headquarters so that the finished product was uniform in all cafeterias.

During the period 1922 to 1939, Waldorf Division's operations were grouped into four geographical divisions, each of which was headed by a superintendent. The superintendent reported directly to the assistant to the president. Next in the chain of command were supervisors, each of whom usually was in charge of a city. Under the supervisors there came the store, or cafeteria, managers within the city. Each store manager was in charge of an operating unit, or cafeteria.

Each division1953 U.S. Tax Ct. LEXIS 28">*42 superintendent had at least one commissary under his supervision. Each local commissary had a manager in charge who took instructions from the division superintendent. Boston headquarters shipped raw material to the local commissaries which prepared the food that was served to the patrons of the cafeterias. The local commissaries made pies, cakes, and pastries in large quantities. They prepared the cooked foods that were listed on the daily menus that were sent out from Boston headquarters. They also prepared food for short-order cooking in the individual cafeterias. The food so prepared in the commissaries was packed in large vacuum cans and delivered daily to the individual cafeterias that were within the geographical division. The cafeterias, on receipt of the large vacuum containers, removed portions and placed them in smaller containers on the steam table. Only enough food was placed in the steam containers to meet what was judged to be the current need. If an unusual run developed for a particular item, the manager of the cafeteria telephoned his supplying commissary and additional supplies were delivered to him. The individual cafeterias did not do any cooking on 1953 U.S. Tax Ct. LEXIS 28">*43 a major scale. They kept warm the cooked foods that were delivered to them from the commissaries. They did short-order cooking, such as the frying of hamburgers, and ham and eggs. ² No real cooking, as such, was done in the cafeterias. No major food items were cooked on the premises of the cafeterias.

21 T.C. 252">*259 In the period 1927 to 1939, commissaries were maintained and operated by Waldorf Division in the cities of Springfield, Worcester, and Boston, Massachusetts; New Haven, Connecticut; Albany, Syracuse, Rochester, New York City, Buffalo, New York; and Providence, Rhode Island. The expenses of operating the commissaries were allocated to the individual cafeterias on the basis of dollar sales.

Waldorf Division carefully watched the activities1953 U.S. Tax Ct. LEXIS 28">*44 of its competitors. It engaged "shoppers" who ate in competing cafeterias, and it required all of its supervisors to eat one or two meals each week in competitors' cafeterias and render weekly reports to Boston headquarters. These records were kept at headquarters, together with records of temperatures, conventions in a particular city, and other pertinent information, for a period of 5 or 6 years, or more.

Competitors: Industry.

The petitioner had a number of competitors in the field in which it operated. Among these were the John R. Thompson Company (hereinafter referred to as Thompson's), Bickford's, Inc., Childs Company, and Horn & Hardart Company. The Horn & Hardart Company operated a chain of restaurants in New York City. Horn & Hardart Baking Company of Philadelphia operated a chain of restaurants in Philadelphia. Unless otherwise distinguished, both will be referred to herein as Horn & Hardart. All were competitors in a low-price field. Childs' prices were slightly higher due to the fact that it gave table service. The several companies mentioned were in competition with each other. The competition consisted in that each operated in the same general manner, that1953 U.S. Tax Ct. LEXIS 28">*45 is, they have centralized buying management and central commissaries in which the major cooking is performed. All operate chains of restaurants. Bickford's and Thompson's are Waldorf's principal competitors. The Horn & Hardart companies operate only in New York and Philadelphia. ³

1953 U.S. Tax Ct. LEXIS 28">*46 Base Period Depression -- Waldorf's Profits Cycle.

In the latter part of 1929, following the break in the stock market, wholesale food prices began to drop. The weighted index numbers of 21 T.C. 252">*260 all foods, on yearly averages (using 1926 as 100), for 1926 and succeeding years through the base period, were as follows:

Retail prices, as shown by average sales to customers, in Waldorf Division's restaurants did not drop as rapidly as wholesale food prices beginning in 1929, nor were they advanced as rapidly as wholesale food prices beginning in 1933. The following tabulation shows average sales to customers in Waldorf's principal subdivisions from 1926 through 1939:

1953 U.S. Tax Ct. LEXIS 28">*47 During the depression following the stock market break in 1929, chain restaurant operators were able to purchase food at favorable prices. Waldorf and other chains did not drop their retail prices ratably with the drop in wholesale prices because there was no certainty that the bottom in prices had been reached, and they did not want to be in the position of having to raise prices in their restaurants if wholesale prices did increase. However, the lowering food costs enabled them to reduce prices to the extent that they were able to attract new customers. Such new customers, some of whom had been accustomed to eating in higher priced restaurants, replaced those who because of loss of jobs were no longer financially able to eat in restaurants.

The income, cost of sales, expenses, and result of operations of the Waldorf Division for the years 1922 to 1939, inclusive, expressed in round figures, were as follows: 21 T.C. 252">*261

Averages:

1953 U.S. Tax Ct. LEXIS 28">*51 The number of customers of Waldorf Division, in each case not including the industrial division, for the years 1922 to 1939 were as follows:

The index of income of all corporations that filed returns in the period 1922 to 1939, using 100 as the index for the entire period, reached a high 191.4 in 1929. In 1930 it was 89.8, in 1931 it was 16.9, and in 1932 it was minus 22.4, which was the depth of the depression that began in 1929. The index figures for the years 1933 to 1939, inclusive, are as follows:

The period 1922 to 1929 was one of expansion and prosperity for the chain restaurant business, particularly that of cafeterias. Operators were picking better locations, paying higher rents, and improving 21 T.C. 252">*263 the appearance, equipment, and methods of operation1953 U.S. Tax Ct. LEXIS 28">*52 of cafeterias.

During the early years of the depression, the low-priced chain restaurants fared well in relation to other businesses. Figures as to John R. Thompson Co. for the years 1928 to 1931, inclusive, are as follows:

The records of Bickford's Inc., for the years 1929 to 1932, inclusive, show the following results:

Figures as to sales of other chain restaurants are:

The number1953 U.S. Tax Ct. LEXIS 28">*53 of food checks issued to customers of low-priced chain restaurants, as far as available, remained relatively constant in the early depression years. The figures as to Childs Company are as follows:

In the case of Waldorf System, the restaurants operated at the close of each of the same years and the customers served in each year were:

21 T.C. 252">*264 Average net income of Waldorf Division for the years 1930, 1931, and 1932 was $ 986,426.

The index of net income of 6 chain restaurants operating in the low-priced field was 114.9 for the years 1929 to 1933 as compared with an index of 100 for the period 1923 to 1939. ⁴

1953 U.S. Tax Ct. LEXIS 28">*54 Wholesale food prices began to rise in 1933. The rise on an annual basis first shows up in figures for 1934. In 1933 the weighted index number of all foods was 60.5 (on the basis of a figure of 100 for 1926); in 1934 it was 70.5, and in 1935 it was 83.7. Low-priced restaurant chains were not able to increase their retail prices to keep pace with the increase in wholesale prices due to several factors. One of these was customer resistance to any increase in prices. Any increase by Waldorf Division in the price of an article on its menu resulted in decreased sales, complaints, letters, and telephone calls. Price increases could be made without loss of sales only after the consumer public had become educated as to the market costs of commodities. Such resistance continued from 1933 to 1939, inclusive.

The low-priced restaurant chains customarily sell food items in multiples of 5 cents, as their customers object to paying odd cents, and on a rising market Waldorf Division often found it necessary to absorb increased costs of odd cents per order until there came a time when it felt that the price at the counter could be increased by a full 5 cents. On what were known as fast selling1953 U.S. Tax Ct. LEXIS 28">*55 items, such an increase in price would often result in a decrease of sales of anywhere from 40 to 60 per cent.

During the period following 1933, labor costs increased substantially. Workers in Waldorf Division and othter chain restaurants were paid higher wages which the operators found it difficult to pass on to customers. Under the National Recovery Act, the hours of Waldorf Division's employees were shortened and their minimum wage levels raised which resulted in increased labor costs in 1933 of $ 125,000. Compliance with provisions of the Restaurant Code in 1934 resulted in a material increase in the cost of labor. In 1936 wages of all Waldorf employees, except supervisors and executives, were raised 10 per cent. In the years immediately preceding 1939, the average hourly wage of Waldorf Division's employees increased by more than 23 per cent, and wage and hour adjustments added over $ 600,000 to its annual payrolls. Social Security taxes averaged $ 105,891 in the period 1936 to 1939.

The result of increased food costs and operating costs, and the inability of operators to pass on the increased costs to customers, was that many low-priced chains ran into financial difficulties1953 U.S. Tax Ct. LEXIS 28">*56 in the period 21 T.C. 252">*265 1933 to 1939. Some went out of business completely and others were forced to reorganize. The number of business failures among such chains during that period was greater than in the whole prior history of the business.

The net income of Waldorf Division, Waldorf System, Inc., with its affiliated corporations on a consolidated basis, of the five restaurant chains above mentioned shown separately and also combined with the income of Waldorf System, and the income of all corporations, are shown in the tabulation below. The dollar amount in each case is net income before taxes, less tax-exempt income, plus interest paid:

Expressing the above dollar amounts in index figures on the basis of the index figure for 1923 to 1939 being 100, gives the following results:

21 T.C. 252">*266 General Business Cycle.

There was a relatively short business depression in the United States in 1921. Thereafter, and into 1929, business conditions generally were rising. Security and commodity prices rose. Production, sales, employment, loans, debts, and interest rates were rising. There was a good deal of capital expansion in industry and of buying durable goods. Towards the end of the period, prices began to level and inventories began to accumulate to a rather unhealthy amount. In September 1929 the securities' market crashed. Immediately sales of durable goods and investments in plant and equipment fell off. This was followed by slumps in sales of other goods, 1953 U.S. Tax Ct. LEXIS 28">*59 and production and employment decreased. This condition continued through 1930 and 1931. The low point in production was reached in 1932, and the low point in employment in 1933. There were many bankruptcies. Debts were scaled down and interest rates were lowered. Plants and equipment and durable goods wore out in the period 1929 to 1933. In 1933 and 1934 consumers started to spend on durable goods and industry started to invest in plants and equipment. Prices started to rise. Earnings of all corporations were on the plus side in 1933 and continued a steady rise through 1937. In 1938 there was a recession, but in 1939 earnings had risen to almost the 1937 level.

Ultimate Facts.

The operation of chain restaurants, such as Waldorf Division, Thompson's, Bickford's, Childs, Horn & Hardart, with a substantial number of units, centralized management, central commissaries, and purveying of food at the lowest price possible consistent with operating at a profit, constitutes an industry of which Waldorf Division was a member in the base period and in the excess profits tax years.

The business of Waldorf Division was depressed during the base period by reason of conditions generally1953 U.S. Tax Ct. LEXIS 28">*60 prevailing in the industry of which it was a member.

The petitioner was subjected to a profit cycle differing materially in length and amplitude from the general business cycle.

A fair and just amount representing the average of normal income during the base period years is $ 782,092.90.

OPINION.

The petitioner claims relief from excess profits tax under the provisions of Code sections 722 (a) and (b) (3) (A). Subsection (a) states the general rule as to relief if the tax is excessive and discriminatory and if the taxpayer establishes a fair and just amount representing normal earnings.

21 T.C. 252">*267 Subsection (b) (3) (A) provides that the tax shall be considered excessive and discriminatory if --

(3) the business of the taxpayer was depressed in the base period by reason of conditions generally prevailing in an industry of which the taxpayer was a member, subjecting such taxpayer to

(A) a profits cycle differing materially in length and amplitude from the general business cycle * * *