27 T.C. 534">*534 Respondent has disallowed petitioner's claims for refund of excess profits tax under section 722, Internal Revenue Code of 1939, for the years 1941 to 1945, inclusive, in the following amounts:

The question in issue is whether1956 U.S. Tax Ct. LEXIS 13">*14 there was a change in the character of petitioner's business within the meaning of section 722 (b) (4) entitling it to the relief sought.

FINDINGS OF FACT.

1. The petitioner is a New York corporation with its principal office located in New York City. Its returns for the years involved, the 27 T.C. 534">*535 calendar years 1941 to 1945, inclusive, were filed with the collector of internal revenue for the third district of New York. The petitioner was organized in 1910 to operate a merchandise bulletin service, and in conjunction therewith a jobbing business. A few years after its organization it began a resident buying business.

2. In its merchandise bulletin the petitioner made periodic reports, sometimes daily, to its subscribers who, for the most part, were retail merchants outside of New York City, on the market conditions for certain types of goods in which they might be interested. It received a flat fee for the bulletin service, based generally on the size of the customer's business.

3. In its jobbing business, the petitioner purchased merchandise for its own account and resold it to its clients at a markup of 1 per cent plus cost.

4. The resident buying business was commenced 1956 U.S. Tax Ct. LEXIS 13">*15 about 1915. It later developed into petitioner's principal business. The petitioner bought merchandise for its clients on their order or at their request. In connection with this service, it furnished its clients office space and facilities whenever desired. In addition, petitioner gave its clients advice and assistance in their retailing business. Petitioner's clients numbered 174 in 1936, 186 in 1937, 181 in 1938, and 225 in 1939.

5. After about 1930 and for some or all of the period here under consideration, the petitioner was the sole owner of the stock of three subsidiary corporations -- Accepted Modes, Inc., Merchandise Reporting Company, and Irving C. Krewson Corporation. These subsidiaries all had the same officers and directors as the petitioner and were in fact mere nominees of the petitioner in whose names some of petitioner's business was transacted. They had no separate business functions and filed no separate tax returns.

6. In its resident buying department, prior to the base period, the petitioner had only one buyer for men's and boys' ready-to-wear clothing. In its women's-wear department, it had one buyer for cloaks and suits, and another for dresses.

7. For1956 U.S. Tax Ct. LEXIS 13">*16 several years prior to the base period, the merchandise bulletins which petitioner furnished its clients contained sketches of various articles of clothing offered for sale by manufacturers. A separate charge was made to the clients for this service which the petitioner posted in its books as other income from "sketches." Its profit and loss statements show sketches income ranging from approximately $ 1,500 in 1933 to approximately $ 4,300 ¹ in 1939.

8. From 1929 to 1936 the petitioner's business was located at 1071 Sixth Avenue, New York City, on rented premises containing about 27 T.C. 534">*536 10,000 or 11,000 square feet of space. On January 13, 1936, petitioner moved to its present location at 225 West 34th Street. This site, also rented, contained about 22,500 square feet of office space. The principal1956 U.S. Tax Ct. LEXIS 13">*17 reason for moving to larger quarters was to make room for the addition of an export business for which the petitioner was then negotiating. These negotiations fell through, however, soon after the move was made, and the petitioner found itself with more space than was needed at the time. Thereafter, from time to time, the petitioner further subdivided some of its buying operations and added new services, as hereinafter explained.

9. One of petitioner's competitors in the resident buying business, Affiliated Buying Corporation, went out of business in 1936 and on September 26, 1936, the petitioner entered into a contract with one of its principal officers, Charles A. Cook, for the transfer to petitioner of some of that company's client accounts. The petitioner agreed to pay Cook 10 per cent of the fees received from those clients for a period of 3 years from October 1, 1936. The petitioner received fees from 5 such clients of $ 457.50 in 1936, $ 1,880 in 1937, $ 2,006 in 1938, $ 2,077 in 1939, and $ 2,232 in 1940. It paid Cook, as the amount due him under the agreement, $ 287.42 in 1937, $ 256.95 in 1938, and $ 134.10 in 1939. The 1939 payment included $ 100 paid to Cook in May1956 U.S. Tax Ct. LEXIS 13">*18 of that year for a general release of his rights under the agreement. Some or all of those clients remained with the petitioner after the base period.

10. The petitioner entered into a similar agreement January 14, 1939, with Harry G. Flanagan, one of the principals in another competitive firm of Rosenthal-Flanagan Associates. Under this agreement, Flanagan was to bring to the petitioner a number of the clients of Rosenthal-Flanagan Associates and was to be employed by the petitioner in its women's ready-to-wear department for a period of at least 11 months beginning February 1, 1939. As his compensation, Flanagan was to be paid a certain percentage of the fees from those accounts, or any other accounts which he might bring in, amounting to 50 per cent on the first $ 1,500, 100 per cent on the next $ 200, and 10 per cent of all in excess of $ 1,700. The petitioner received fees in 1939 from 22 of such accounts of $ 18,816. Some or all of those clients remained with the petitioner after 1939.

11. At Flanagan's suggestion and under his supervision, the petitioner expanded its business by establishing two new divisions called Centralized Merchandising Division (C. M. D.) and Merchandising1956 U.S. Tax Ct. LEXIS 13">*19 Control Division (M. C. D.). C. M. D. was referred to as "unit inventory control" service. Its purpose was to keep the inventories of existing clients at certain basic seasonal levels. The unit inventory control service had been in use by resident buyers for a number of years. An additional fee was charged by the petitioner for this service. Such fees amounted to $ 2,580.35 in 1940, $ 3,803 in 1941, and $ 1,450 in 1942.

27 T.C. 534">*537 12. M. C. D. functioned about the same as C. M. D. except that it was for new clients only in their purchases through the petitioner's coat and suit department. The petitioner received fees from this service of $ 5,519 in 1941 and $ 19,786 in 1942.

13. In each of the years 1937, 1938, and 1939, the petitioner received fees from one of its clients of $ 150 for furnishing the client certain newspaper mats which it used in promoting its sales. These payments were entered in petitioner's books as income from "retail advertising division service (R. A. D.)." During the same years the petitioner maintained a similar service for other clients, called R. A. D. promotion, from which it received fees of $ 761.64 in 1937, $ 1,397.69 in 1938, and $ 141.58 in 1939.

1956 U.S. Tax Ct. LEXIS 13">*20 14. In the latter part of 1939, the petitioner had prepared and distributed to its subscribers a so-called Fabric Book which contained samples and descriptions, and also a price list, of various fabric materials currently offered to the trade. The Fabric Book was distributed to regular resident buyer subscribers without charge but the petitioner received a fee from the manufacturers for the display of their merchandise in the book. The fees so received by the petitioner amounted to $ 461.50 in 1939 and $ 369.12 in 1940, after deduction of the costs of having the book made up.

15. Also, in 1939, petitioner had prepared a Christmas catalog in which merchandise suitable for Christmas presents was advertised. The books were sold to subscribers at about their cost to the petitioner and the manufacturers were charged for the advertisements, as in the case of the Fabric Book. The petitioner's income from this source amounted to $ 1,688 in 1939 and $ 964.65 in 1940, after deduction of the costs incurred in the catalog's preparation.

16. During February 1939, petitioner commenced operations under a contract with Sopic Trading Company (hereinafter referred to as Sopic), which for some time1956 U.S. Tax Ct. LEXIS 13">*21 had been conducting a resident buying and jobbing service for foreign clients. Under this agreement, Sopic was given use of petitioner's office and facilities to conduct its foreign business, in consideration for which it was to pay petitioner a flat fee of $ 840 a year, plus a service charge of 1 per cent of the cost of merchandise purchased by Sopic but billed to petitioner, plus a percentage of Sopic's gross profits, as specified in the agreement. The gross amounts received by petitioner under its agreement with Sopic amounted to $ 433.02 in 1939.

17. For several years prior to 1936 petitioner charged manufacturers for the privilege of having their products advertised in the merchandise bulletins which it regularly furnished its clients, and entered the amounts so received in its books under the heading "Sketches." The amounts so received are set out in petitioner's profit and loss statements as shown in paragraph 19 below.

27 T.C. 534">*538 18. The petitioner's net sales, gross profits from sales, service fees as resident buyer, other income, and its net income (or losses) as adjusted by revenue agents, for the year 1922 to 1939, inclusive, were as follows:

1956 U.S. Tax Ct. LEXIS 13">*22 19. The following items taken from petitioner's profit and loss statements for the base period years show the separate items making up petitioner's "other income" and the deductions taken in determining its net income or loss for each year:

1956 U.S. Tax Ct. LEXIS 13">*23 27 T.C. 534">*539 20. Petitioner's excess profits credit, computed under the invested capital method, and the excess profits tax paid, for the taxable years 1941 to 1945, inclusive, are as follows:

21. The stipulated facts are incorporated herein by reference.

OPINION.

Petitioner contends that its average base period net income is an inadequate standard of normal earnings because of certain base period changes in the character of its business within the purview of section 722 (b) (4), Internal Revenue Code of 1939. These alleged changes consist of (1) moving its offices to a larger, new location, (2) acquiring new clients through contracts with former competitors, and (3) changing and enlarging its operations by providing new types of service for its clients.

Petitioner moved its offices from 1071 Sixth Avenue, New York City, to 225 West 34th Street, in January 1936. The new offices contain about double the amount of space of the old offices. Petitioner contends that the additional space1956 U.S. Tax Ct. LEXIS 13">*24 resulted in an increased volume of resident buying business.

The additional office space undoubtedly afforded petitioner the means of expanding its business. However, proof is lacking that before the move the business was suffering because of any lack of space or that there was any increase either in gross business or in net income directly attributable to the use of the additional office space. The evidence is that the additional space was acquired for the purpose of making room for an export business, which, however, was not acquired. Neither is there any showing that the benefits from the move were not substantially reflected in petitioner's base period earnings. The move was made early in 1936. There is no support for petitioner's contention that the results of the move were not fully reflected in its operations until 1939.

Petitioner's service fees as resident buyer were considerably greater for a number of years before the office move than they were for several years afterwards. The 10-year, 1922-1931, average was in excess of $ 113,000, although the 1932-1935 average fell off to about $ 86,500. The fees amounted to $ 96,064.33 in 1936, $ 107,060 in 1937, $ 104,459.741956 U.S. Tax Ct. LEXIS 13">*25 in 1938, and $ 120,989 in 1939. While, as shown, there was an increase in fees of approximately $ 10,000 a year in 1936 and 1937 following 27 T.C. 534">*540 the office move, there was a decrease of approximately $ 2,500 in 1938 compared with the previous year. This would indicate that the amount of petitioner's resident buying service fees was not dependent upon the amount of office space. On the evidence of record, we cannot find that the move to the new offices resulted in any substantial increase in petitioner's level of earnings. The change, therefore, is not such a change as would entitle petitioner to relief under section 722 (b) (4). See Granite Construction Co., 19 T.C. 163; Central Produce Co., 18 T.C. 267; Toledo Stove & Range Co., 16 T.C. 1125; Wisconsin Farmer Co., 14 T.C. 1021.

Petitioner claims that the contracts which it entered into with Charles A. Cook and Harry G. Flanagan whereby it acquired new clients and made certain changes in its operations were changes in the character of its business within the meaning of that portion of section 7221956 U.S. Tax Ct. LEXIS 13">*26 (b) (4) which defines as a change in the character of the business "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."

Assuming without deciding that the contracts entered into with Cook and Flanagan come within the qualifying provision of section 722 (b) (4), supra, such assumption, as will be shown later in this Opinion, will not help petitioner unless it establishes a constructive average base period net income under section 722 (a) of such magnitude as will produce an excess profits credit in excess of the credit allowed petitioner under section 714 of the 1939 Code.

Petitioner also claims that it had a "change in the character of the business" within the meaning of that term as used in section 722 (b) (4) by reason of the so-called C. M. D. and M. C. D. plans which it put into operation at Flanagan's suggestion while he was in petitioner's employment. This amounted to nothing more than charging the clients a separate fee for services in keeping their inventories at certain basic seasonal levels. It does not appear that these services required any substantial1956 U.S. Tax Ct. LEXIS 13">*27 change in petitioner's operations or that they amounted to anything more than bookkeeping changes and the normal expansion of the business. Furthermore, we have no proof that the changes, whatever their nature, were made before the end of the base period as required of qualifying changes.

Other changes in character claimed by petitioner include the so-called R. A. D. and R. A. D. promotions services, the distribution to clients of the Fabric Book and Christmas catalog, the operation of the business called Sketches, and the so-called Sopic transaction.

The so-called R. A. D. and R. A. D. promotions services in which petitioner furnished some of its clients certain newspaper advertising 27 T.C. 534">*541 mats for small fees were even less important changes in petitioner's operations than were the C. M. D. and M. C. D. services. So, also, was the distribution to clients of the Fabric Book and Christmas catalog. At most, they were nothing more than minor additions to petitioner's regular services for its clients as a resident buyer and jobber. The statute was intended to afford relief only where there have been important changes which substantially affected the taxpayer's earnings. In Avey Drilling Machine Co., 16 T.C. 1281, 1298,1956 U.S. Tax Ct. LEXIS 13">*28 we said that "A change in character, within the intent of the statute, must be a substantial departure from the preexisting nature of the business." None of the changes claimed here was of such a nature.

Regarding the operation of the department of the business called Sketches, petitioner did not request any findings of fact with respect to this item in its proposed Findings of Fact. It does not contend that this was a new activity commenced during the base period but argues that this department was organized and expanded during the base period, so that the normal level of earnings was not reached until December 1939. It is enough to say that the record is wholly lacking in evidence of any reorganization or expansion of this phase of petitioner's business that could qualify as a substantial change in the character of the business.

In the so-called Sopic transaction which took place in February 1939, petitioner agreed to permit Sopic Trading Company to use its offices and facilities, to furnish the same type of services to foreign clients as petitioner furnished to its domestic clients. Petitioner had no foreign clients of its own. In consideration for the use of its office space1956 U.S. Tax Ct. LEXIS 13">*29 and facilities, petitioner was to receive a flat fee of $ 840 a year, plus a percentage of the gross amounts received from these foreign clients. The total amount received by petitioner from Sopic under this agreement amounted to $ 433.02 in 1939.

Petitioner contends that under its arrangement with Sopic it must be regarded as having changed the character of its business either by entering into the export business or by partially absorbing a competitor's business. Petitioner seeks to include in its constructive income for each base period year the fixed annual fee of $ 840, plus an assumed additional income of $ 1,560 in 1936, 1937, 1938, and $ 1,126 ($ 1,560 less $ 433.02) for 1939. We will assume that under its contract with Sopic for sharing office space and facilities for certain fees the petitioner made changes in the operation of its business within the meaning of section 722 (b) (4). Petitioner had not previously operated under any such plan. We may assume, further, that this change increased petitioner's potential gross income in the approximate amount claimed by the petitioner. However, these proposed additions to constructive base period income are at best gross income1956 U.S. Tax Ct. LEXIS 13">*30 27 T.C. 534">*542 and not net income. This is also true of the adjustments claimed on account of the other alleged changes, with exception of the fees charged for the Fabric Book.

We have carefully considered all of the claims made by petitioner and we think petitioner has failed to show that if all of these alleged changes had been made 2 years earlier its earning level at the end of the base period would have been substantially larger than it was. In order for petitioner to obtain any relief, it would have to establish a constructive average base period net income of such magnitude that 95 per cent thereof would exceed its excess profits credit, computed under the invested capital method, for each of the excess profits tax taxable years, ranging from a low of $ 10,287.62 in 1943 to a high of $ 11,879.60 in 1945. Green Spring Dairy, Inc., 18 T.C. 217; Godfrey Food Co., 18 T.C. 1083; and Gillen & Boney, 27 T.C. 242. Petitioner's actual average net income for the 18-year period from 1922 to 1939, inclusive, was $ 3,260.02. For the base period years it had an actual average net loss of $ 1,194.82. 1956 U.S. Tax Ct. LEXIS 13">*31 Its actual excess profits net income for the last year of the base period, after these alleged changes had been made, was $ 3,815.75, or about 2.65 per cent of its gross. Notwithstanding these actual happenings, petitioner contends that if the alleged qualifying changes mentioned above had been commenced 2 years sooner, its constructive average base period net income would have been at least $ 40,000. It arrives at this average figure by reconstructing for each of the base period years a certain amount of additional gross income without reconstructing any expenses in earning such additional income. As indicated above, the actual net for 1939 was less than 3 per cent of the gross income. This percentage of $ 40,000 would amount to about $ 1,200 which is a long way from an amount 95 per cent of which would exceed the excess profits credits allowed under the invested capital method.

Since the invested capital credit amounted to over $ 10,000 in each of the taxable years, petitioner would need to convert its average base period loss of approximately $ 1,194 into a constructive average base period net income greater than $ 10,900. We cannot find on the evidence of record that reasonable1956 U.S. Tax Ct. LEXIS 13">*32 adjustments of base period net earnings for any or all of the alleged changes claimed by the petitioner would produce a constructive average base period net income of such proportion.

Respondent's action in disallowing petitioner's claims for relief is therefore sustained.

Reviewed by the Special Division.

Decision will be entered for the respondent.