26 T.C. 442">*442 The petitioner seeks review of the respondent's disallowance of its applications for relief under section 722 of the Internal Revenue Code of 1939.

The testimony was taken before a commissioner of this Court and his findings of fact were duly served on the parties. Objections thereto presented 1956 U.S. Tax Ct. LEXIS 182">*183 by counsel for the respective parties have been considered. We make the following Findings of Fact.

FINDINGS OF FACT.

The stipulated facts are found as stipulated and exhibits attached thereto are incorporated by this reference.

Petitioner is a corporation organized under the laws of the State of New York, April 18, 1929. Its principal place of business is Long Island, New York. Its income and excess profits tax returns for the years involved, the fiscal years ended March 31, 1944, 1945, and 1946, were filed with the collector of internal revenue for the second district of New York.

From the date of its incorporation until about the end of 1933, petitioner's sole business was acting as manufacturers' agent or broker for the grocery industry. With the repeal of national prohibition, petitioner, in December 1933, obtained a license to handle liquors, in addition to groceries, in New York State, and acquired the necessary 26 T.C. 442">*443 licenses and import permits for that business. Commencing in December 1933 it made sales both to wholesalers and to retail outlets in New York City and New York State outside the city. Licenses and permits were later obtained to operate in New Jersey1956 U.S. Tax Ct. LEXIS 182">*184 and Connecticut. An office was opened in New Jersey to import liquors on November 1, 1934. A similar office was opened in Connecticut during that year. Early in 1935 petitioner ceased distributing to wholesalers in New York City and in that area concentrated on its wholesale business selling to the retail trade. As an importer's agent, petitioner acted as agent for foreign manufacturers. It sold the imported liquors to wholesalers who, in turn, sold to the retailers. As a wholesaler, petitioner sold and distributed to retailers. Under the laws of the State of New York petitioner was permitted to operate in both capacities. In addition to its regular wholesale and distribution business, petitioner sometimes handled liquor orders for other distributors or dealers at a small profit. These were referred to as clearance transactions.

At first, petitioner was limited in its liquor supplies, both foreign and domestic. It was able to obtain only a few comparatively small distributorships. It expanded its business and during the base period acquired distributorships from several large distributors, including National Distillers and Brown-Forman Distillers Corporation. These were1956 U.S. Tax Ct. LEXIS 182">*185 acquired during 1937.

Among the better known trade brands handled by petitioner during the base period were: Teachers' Highland Cream, a Scotch whiskey, Hennessey's cognac, Martini-Rossi vermouth, Government House rum, and Duff Gordon sherry.

For some time after repeal of national prohibition there was a scarcity of most types of alcoholic beverages, and competition in the sales end of the industry was not severe. During the base period years, however, production exceeded consumption, so that by the end of 1939 large supplies had been built up and the competitive situation had become more pronounced. This was especially true of the bonded whiskeys, which had accumulated in large quantities. Whiskey stocks at the close of 1939 were several times larger than the consumption for that year.

Some of the liquors handled by the petitioner, particularly the Scotch and the cognac, were in short supply and were on allocation to petitioner during the base period. Teachers' Scotch whiskey was on allocation in 1937 and thereafter. Cognac was on allocation from about September 1939. Some other types of liquors handled by the petitioner and its competitors were not so much in demand, and at1956 U.S. Tax Ct. LEXIS 182">*186 times were in oversupply.

Petitioner's liquor operations were divided into four zones consisting of metropolitan New York, the State of New York other than the 26 T.C. 442">*444 city, and the States of Connecticut and New Jersey. The sales, gross profits, expenses, and net profits of the liquor business for each of such divisions for the fiscal years ended March 31, 1936 to 1940, inclusive, were as follows:

1956 U.S. Tax Ct. LEXIS 182">*187 In determining the above-shown expenses, petitioner did not allocate to the various divisions any of the salaries of its two principal officer-stockholders, Seggerman and Nixon. (The month by month profits of each separate division, after manager's participation but before salaries of Seggerman and Nixon, for the taxable years 1939 to 1940 and for the calendar year 1940, are set forth in Exhibits H, I, and J. The detailed expenses for the Metropolitan, New Jersey, and Connecticut divisions for each of the years 1936 to 1940, inclusive, are shown in Exhibits 1 to 5, inclusive. The exhibits referred to -- H, I, J, 1, 2, 3, 4, and 5 -- are incorporated herein by reference.)

The profits of the grocery business for the fiscal years ended in 1936 to 1940, inclusive, were, respectively, $ 10,841.55, $ 46,334.04, $ 31,597.35, $ 35,158.78, and $ 39,879.40.

Petitioner's returns for the fiscal years ended in 1937 to 1940, inclusive, showed the following amounts of compensation, including salaries and participating shares of profits, paid to its officers:

1956 U.S. Tax Ct. LEXIS 182">*188 26 T.C. 442">*445 H. T. Slocum was made second vice president in charge of the New York State Division, December 27, 1935. R. L. Darnall became third vice president in charge of the New Jersey Division, November 19, 1936.

Petitioner's original authorized capital stock consisted of 300 shares of no par value. Ninety-five shares were subscribed for by Frederick T. Seggerman, 20 shares by Frederick J. Nixon, and 5 shares by two other persons. Seggerman became petitioner's president and Nixon vice president and secretary. Their stockholdings as of May 4, 1937, were 72 shares and 48 shares, respectively.

In June 1937 petitioner put into effect a plan of reorganization and recapitalization under which 1,230 shares of new no-par-value common stock and the same number of $ 100-par-value noncumulative preferred shares were issued in exchange for the outstanding old shares at the rate of 10 1/4 shares of each type of new stock for 1 share of the old. The new preferred shares were set up in petitioner's books at their par value of $ 123,000, and that amount was transferred from surplus to capital stock account. Between June 28, 1937, and March 31, 1938, 770 additional units consisting of 1 share1956 U.S. Tax Ct. LEXIS 182">*189 of each type of stock were sold to employees and others at a price of $ 110 per unit. Shares of a par value of $ 42,500 were issued to the two principal stockholders, Seggerman and Nixon, in part payment of loans amounting to $ 56,000 which they had previously made to petitioner.

The following is a summary of petitioner's outstanding capital stock at the close of each of the years ended March 31, 1930 to 1940, inclusive:

The shares issued in 1939 and 1940 were issued for cash.

Petitioner's surplus account at the end of each of the fiscal years ending March 31, 1930 to 1940, inclusive, was as follows:

1956 U.S. Tax Ct. LEXIS 182">*190 26 T.C. 442">*446 Petitioner's balance sheets for the years ending March 31, 1936 to 1940, inclusive, show the following assets and liabilities:

The ratio in terms of percentage of petitioner's excess profits net income to year-end net worth, for each of the fiscal years ended March 31, 1936-1940, inclusive, is shown by the following table:

1956 U.S. Tax Ct. LEXIS 182">*192 Petitioner's increased capitalization strengthened its financial standing and enabled it to secure better bank credits. A credit of $ 300,000 was extended to petitioner by its banks in September 1939, to finance its unusually heavy volume of business following the outbreak of war in Europe.

26 T.C. 442">*447 On March 31, 1939, petitioner had a total credit of $ 200,000 with the Hanover Bank and the Bank of Manhattan Co. On March 31, 1940, petitioner had borrowed from the banks the sum of $ 250,000.

In metropolitan New York there was keen competition between the liquor wholesalers and distributors, particularly in the latter half of the base period. This brought about price cuts and various trade discounts and allowances, especially in blended liquors, and advancement of liberal credit by distributors and wholesalers. It did not affect petitioner's import business.

Following the outbreak of the war in Europe early in September 1939, there was a sharp increase in the importation of whiskey and brandy into the United States. In September 1939 the whiskey imports were about 2 1/2 times and the brandy imports about 3 times those of September 1938.

Monthly averages of total imports of alcoholic1956 U.S. Tax Ct. LEXIS 182">*193 beverages and distilled spirits during the years 1936 to 1940, inclusive, were as follows:

During the last 4 months of 1938 petitioner's liquor sales amounted to $ 1,289,000 or 44.7 per cent of petitioner's total 1938 liquor sales of $ 2,886,000. During the last 4 months of 1939 petitioner's liquor sales amounted to $ 1,665,000 or 45.7 per cent of petitioner's total 1939 liquor sales of $ 3,645,000.

The Federal tax on distilled spirits was paid either by the distiller at the time the liquor left the distillery for distribution to consumers or, in the case of bonded liquor, by the purchaser at the time it was withdrawn from the bonding warehouse. During the base period the tax on bonded liquor had to be paid when the liquor became 4 years old, although it was still held in bond. This period was later extended to 8 years.

The following table shows the gallons of distilled liquors sold in the States of Connecticut, New Jersey, and New York, during the years 1936 to 1939, inclusive:

26 T.C. 442">*448 Petitioner's excess profits net income for the base period years ended March 31, 1937 to 1940, inclusive, its average base period net income, arithmetic and as computed under section 713 (f) of the Internal Revenue Code, are as follows:

Petitioner's excess profits net income, average base period net income, the capital additions or deductions, and the excess profits credits for each of the years 1941 to 1946, inclusive, are as follows:

The petitioner's average base period net income, as computed under section 713 (f), is not an inadequate standard of normal earnings.

OPINION.

The petitioner asks for relief pursuant to section 722 (a) and subparagraphs (2), (4), and (5) of section 722 (b), Internal Revenue Code of 1939, ¹ from allegedly excessive and discriminatory 26 T.C. 442">*449 excess profits taxes for fiscal years ended in 1944, 1945, and 1946.

1956 U.S. Tax Ct. LEXIS 182">*196 The petitioner computed its excess profits credit under the average earnings method. In order to qualify for relief under section 722 the petitioner must show that its average base period net income is an inadequate standard of normal earnings because of one or more of the factors specified in section 722 (b) and to establish what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income. The terms "standard of normal earnings" and "fair and just amount representing normal earnings" are regarded as synonymous. See E. P. C. 16, 1947-1 C. B. 90. The petitioner's average base period net income as computed under section 713 (f) is $ 96,921.63. Unless the petitioner shows that it qualifies for relief because of one or more of the factors specified in section 722 (b) and also can establish a fair and just amount representing normal earnings in excess of this figure, its average base period net income is not an inadequate standard of normal earnings and it is not entitled to relief. In our opinion the petitioner has not carried its burden of proof in either respect and accordingly has not qualified1956 U.S. Tax Ct. LEXIS 182">*197 for relief under section 722.

26 T.C. 442">*450 The arithmetical average of petitioner's base period net income was $ 66,460.22 and the best base period year prior to the last year had excess profits net income of $ 69,902.84. The average base period net income as computed under section 713(f) is equal to the amount of the petitioner's excess profits net income for the last base period year.

The petitioner contends that certain changes in the character of its business occurred during or immediately prior to the base period which affected its earnings and that its business did not reach by the end of the base period the earning level it would have reached had the changes been made 2 years earlier. Also, it contends that its earnings in the last base period year were depressed because of a price war. The petitioner proposes several constructive average base period net incomes ranging from $ 155,824 to $ 359,300.

Prior to December 1933 petitioner's business was operating as manufacturer's agent and grocery broker. The petitioner secured licenses and acted as importers' agent and direct importer selling imported liquors and wines to some 30 liquor wholesalers in New York City after December1956 U.S. Tax Ct. LEXIS 182">*198 1933 and to others in Connecticut and New Jersey late in 1934. Petitioner argues that this constitutes commencement of this business immediately prior to the base period and says that the formative stage had not been fully completed by the beginning of the base period, citing Midwest Liquor Dealers, Inc., 20 T.C. 950, 964.

Petitioner also contends that it changed the character of its business in the metropolitan area in 1935 by becoming a liquor wholesaler. Prior thereto it was acting as an importer and importers' agent selling to some 30 wholesalers in that area. After this change petitioner sold to retail dealers in the area and had some 14,000 potential customers, all the licensed retail dealers. The petitioner thereafter required larger forces for sales, handling stock, and trucking and had to find new and larger sources of supply.

Petitioner further contends that it changed the character of its business during the base period by increasing its capital, resulting in an increase in its borrowing power and thus in its capacity for operation. In July 1937, $ 123,000 was transfered from the surplus account to preferred stock and 1,230 shares of1956 U.S. Tax Ct. LEXIS 182">*199 preferred stock were issued. Additional units of preferred and common stock were issued for $ 84,700. During the base period the net worth of petitioner increased from about $ 100,000 to about $ 350,000. The increase in capitalization enabled petitioner to increase its borrowings from banks. These were $ 50,000 at the commencement of the base period, increased to a maximum of $ 300,000, and amounted to $ 250,000 at the end of such period. The increase in available funds permitted petitioner to increase its inventory both as to volume and number of items, resulting in greater turnover and increased profits.

26 T.C. 442">*451 It is also contended that the petitioner changed the character of its business in 1937 by acquiring distributorships from several large distributors including National Distillers and Brown-Forman Distillers Corporation.

Petitioner was operating as a manufacturer's agent and broker in the grocery business and had a functioning distributing organization prior to 1934. In entering the liquor business it used this distributing organization and was not under the necessity of creating one. This factor distinguishes Midwest Liquor Dealers, Inc., supra,1956 U.S. Tax Ct. LEXIS 182">*200 cited by the petitioner, where the taxpayer was not organized until 1935. There was no problem of selling liquor in the early years after repeal of prohibition, the sole difficulty lay in procuring the merchandise to sell. Petitioner apparently achieved a level of earnings almost at once which may be regarded as normal for its then available capital and resources. Its ratio of net income to year-end net worth was not increased after the first base period year. See Harlan Bourbon & Wine Co., 14 T.C. 97 (1950). We cannot say that petitioner has proved that its entry into the liquor business occurred immediately prior to the base period within the meaning of the statute, and that on that account petitioner did not achieve a normal level of earnings during the base period. See Monarch Cap Screw & Manufacturing Co., 5 T.C. 1220, 1231 (1945) (change made in 1934); Acme Breweries, 14 T.C. 1034, 1055 (1950) (change in 1933); A. B. Frank Co., 19 T.C. 174, 181 (1952) (change in 1933); West Flagler Amusement Co., 21 T.C. 486 (1954)1956 U.S. Tax Ct. LEXIS 182">*201 (change on October 1, 1933).

Nor do we regard the evidence as showing that petitioner changed the character of its business in 1935 by becoming a liquor wholesaler. Its first operations embraced sales to wholesalers and to retail outlets and it was licensed to deal at both of these levels. Apparently it proved to be more profitable for the petitioner to concentrate on sales to retail dealers and to reduce or abandon its sales to wholesalers. We think this did not amount to a change in the character of the business within the purport of the statute. Although petitioner says that it had to adopt new methods in marketing, delivery, and distribution and administration, these have not been described and there is no showing of the nature or extent of these changes or their effect upon earnings.

The acquisition by the petitioner of distributorships for National Distillers and Brown-Forman in 1937 did not amount to a change in the character of the business. It appears that the practice of the petitioner was to acquire new distributorships from time to time and drop them if they proved unprofitable. The Brown-Forman distributorship was terminated when the distiller formed its own distributing1956 U.S. Tax Ct. LEXIS 182">*202 organization. The National Distillers' brands proved unprofitable 26 T.C. 442">*452 because of an attempt to market various blended whiskeys. It has not been shown that a higher level of earnings resulted from these distributorships. Nor can this be said to mark a new method of doing business.

It has not been shown that the foregoing changes had any material effect upon the petitioner's level of earnings.

There has been no showing of the extent of the economies, if any, effected by the change in business location in 1938. We are unable to say that this change would materially have affected the petitioner's earnings had it occurred 2 years earlier.

The increase in capitalization effected in 1937 and 1938 apparently enabled the petitioner to enlarge its inventory, increase its sales, and achieve a somewhat higher level of earnings. The earnings level of the fiscal years ended in 1937 and 1938 averaged about $ 50,000. In the next fiscal year this was increased to about $ 70,000, and the increase may well have been due to the increased capital of the corporation. In the last base period year the income was affected by other factors. Even if the increase in earnings to approximately $ 1956 U.S. Tax Ct. LEXIS 182">*203 97,000 in that year may be regarded as due to this change in the character of the business, we do not consider this as proving that 2 more years of operation would have enabled the petitioner to reach a level of earnings considerably greater than that. And because of the other factors affecting the earnings of that year we are unable to accept the conclusion that the increase in earnings in such year was primarily due to the increase in capitalization. While the added capital may have enabled the petitioner to take advantage of an opportunity for exceptional profits, it did not cause those profits. See Green Spring Dairy, Inc., 18 T.C. 217.

Two other factors substantially affected the earnings of petitioner's last base period year, one tending to reduce, the other to augment, these earnings. The petitioner argues that its earnings for such year were greatly depressed by a price war affecting its business in its Metropolitan division and forcing the granting of excessive discounts and allowances to its customers. These amounted to $ 91,150.05 or about 5 per cent of the gross sales of that division. In the New Jersey and Connecticut divisions the1956 U.S. Tax Ct. LEXIS 182">*204 petitioner did not find it necessary to grant discounts or allowances. The argument is made that the price war was a temporary economic circumstance depressing the petitioner's business and was a qualifying factor for relief under section 722 (b) (2) and that if petitioner had not been under the necessity of granting such discounts its profits for that fiscal year would be larger by the amount of such discounts.

We think the evidence is not sufficient to establish that the reduced level of earnings of the petitioner's Metropolitan division was due to 26 T.C. 442">*453 a temporary and unusual economic circumstance within the meaning of section 722 (b) (2). In Harlan Bourbon & Wine Co., supra, we pointed out (pp. 104-6) the nature of the competition which developed in the newly revived liquor industry in the base period when many concerns sought to enter the field. We concluded from the evidence there presented that keen competition must be considered normal in the liquor industry. Here, the petitioner has not shown that the competition resulted in severe losses or sales below cost in the base period, an essential characteristic of a price war. Nor is it 1956 U.S. Tax Ct. LEXIS 182">*205 shown that petitioner and other members of the industry suffered severe losses or that a substantial number of wholesalers were eliminated and were unable to stay in business. In fact the petitioner still had some profits and increased the salaries of its officers in these years. This last circumstance tends to deny that the business was depressed by the existence of a price war. Blaisdell Pencil Co., 16 T.C. 1469, 1481-2 (1951). The testimony was to the effect that the condition became serious in 1940 and that price cutting occurred because inventories had become over large. Production had exceeded consumption for several years and reduction in prices necessarily followed with resultant reduction in profits. It was an ordinary and permanent economic situation in the liquor industry; not a temporary and unusual economic event. See Empire Liquor Corporation, 25 T.C. 1183 (1956). In this state of keen competition the petitioner may not expect as large a percentage of profit as it had enjoyed before. Nor would these facts warrant the conclusion that the entire amount of discounts should be added back to income in a1956 U.S. Tax Ct. LEXIS 182">*206 reconstruction of normal income. The sales level achieved in the year was reached only by granting these discounts. An assumed normal percentage of profit should not be applied to such sales in a reconstruction of normal earnings. Thus while the keen competition may have depressed the petitioner's income in this year to some extent, it is not a basis for relief under section 722 and the method of reconstruction proposed by the petitioner to determine a normal level of earnings is unwarranted.

The other principal factor affecting the petitioner's earnings in the last base period fiscal year was the abnormally high level of sales and profits realized in the month of September 1939 as a result of war scare buying following the outbreak of war in Europe. Statistics show that there was a marked increase in imports in September 1939, imports of whiskey being 2 1/2 times and brandy imports about 3 times those of September 1938. The petitioner borrowed $ 300,000 from its banks to finance its unusual volume of business at this time. Petitioner's profits for September 1939 amounted to $ 59,574.52. The next best month in petitioner's last 2 base period years was the following 26 T.C. 442">*454 1956 U.S. Tax Ct. LEXIS 182">*207 month, October 1939, when profits amounted to $ 12,249.34. Profits for the entire calendar year 1939 were about $ 114,500 or an average of about $ 9,500 per month. For 11 months of 1939 excluding September they were about $ 55,000, or about $ 4,600 per month. The profits of September alone were greater than profits for the other 11 months in the calendar year 1939 or in the fiscal year ended in 1940. In view of this abnormal profit for 1 month we cannot regard the profits of nearly $ 97,000 for the fiscal year ended in 1940 as representative of normal growth in comparing them with the profits of the preceding fiscal years. The profits of September 1939 were war derived and were temporary. It would not be reasonable to regard them as a measure of normal earnings upon the basis of events or conditions existing on or prior to December 31, 1939. These profits should be adjusted substantially downward in measuring normal earnings.

The petitioner has not established that it qualifies for relief because of one or more of the factors specified in section 722 (b).

Additionally, the constructive average base period net incomes proposed by the petitioner are founded upon assumptions as1956 U.S. Tax Ct. LEXIS 182">*208 to a further increase in sales and profits which we consider unwarranted from the record. We do not deem it necessary to discuss these computations in detail. Upon consideration of all the factors involved we are satisfied that the base period net income as computed under section 713 (f) is not an inadequate standard of normal earnings and that the petitioner is not entitled to relief under section 722.

Reviewed by the Special Division.

Decision will be entered for the respondent.