14 T.C. 1021">*1022 This proceeding arises from the Commissioner's disallowance of petitioner's claim for refund filed under the provisions of section 722 (b) (4) and (b) ( 5) of the Internal Revenue Code, ¹ for the fiscal year ended May 31, 1941.

1950 U.S. Tax Ct. LEXIS 186">*189 The sole question presented is whether the petitioner is entitled, under the provisions of either section 722 (b) (4) or section 722 (b) (5) of the Internal Revenue Code, to a refund of all or any part of the excess profits tax paid for the fiscal year ended May 31, 1941.

FINDINGS OF FACT.

Petitioner is a corporation, organized on May 9, 1929, under the laws of the State of Wisconsin, with its principal office in Racine, Wisconsin. Petitioner's excess profits tax return for the taxable year ended May 31, 1941, was filed with the collector of internal revenue for the district of Wisconsin. At all times pertinent to the issues herein petitioner's books were kept and its tax returns filed on the accrual basis, with a fiscal year ending May 31.

Petitioner paid excess profits tax for the taxable year ended May 31, 1941, in the net amount of $ 1,003.46. On August 10, 1944, petitioner filed an application for relief under section 722 of the Internal Revenue Code, claiming a refund of the entire amount of excess profits tax of $ 1,003.46. Petitioner's application for relief was disallowed by the Commissioner in a notice of disallowance dated August 22, 1945.

Petitioner was incorporated1950 U.S. Tax Ct. LEXIS 186">*190 on May 9, 1929, for the purpose of taking over the publication of two farm papers. These papers were consolidated by petitioner and published under the name of "Wisconsin Agriculturist and Farmer" at its plant in Racine, Wisconsin, continuously from May 9, 1929, to the date of the hearing herein. At all times petitioner has maintained a continuous circulation level of approximately 175,000 copies per issue. Since any increase in the circulation level would cause higher costs without a corresponding growth in advertising income, petitioner has made no attempt to increase the number of its subscribers beyond 175,000.

During its entire existence, petitioner employed a number of circulation 14 T.C. 1021">*1023 solicitors who called upon farmers in petitioner's territory for the purpose of obtaining new and renewal subscriptions. As an inducement to subscribers, the solicitors offered premiums, including low cost accident insurance policies.

From January 10, 1930, to February 9, 1940, inclusive, petitioner offered its subscribers two types of accident insurance policies, the "All-Risk, All-Coverage Accident Policy," which cost the subscriber $ 3.50 per annum, and the "All-Coverage Accident 1950 U.S. Tax Ct. LEXIS 186">*191 Policy," which cost $ 2.50 per annum. These policies were issued by the National Casualty Co. of Detroit, Michigan, and in connection therewith the Hickey-Mitchell Co., of St. Louis, Missouri, acted as its agent. Throughout this period, petitioner operated under a contract with Hickey-Mitchell under which it received a commission of 95 cents on the policies which sold for $ 3.50 and 45 cents on the policies which sold for $ 2.50. Settlements of losses claimed under such policies were handled either by representatives of Hickey-Mitchell or National Casualty.

The contract between the petitioner and Hickey-Mitchell Co. provided that the contract would be automatically renewed for a period of 12 months unless notice in writing by either party to cancel the contract was given at least 30 days before the end of an annual contract period. The contract between petitioner and Hickey-Mitchell Co., as last renewed, covered the 12-month period commencing February 10, 1939, and ending February 9, 1940. The contract was canceled by petitioner on February 9, 1940, pursuant to a notice of cancellation dated January 6, 1940. Under the provisions of the contract with Hickey-Mitchell Co., petitioner1950 U.S. Tax Ct. LEXIS 186">*192 had no right to solicit and sell the policies of any company other than the National Casualty Co. prior to February 10, 1940. Petitioner continued to sell and obtain renewals of the accident policies issued by National Casualty up to and including February 9, 1940.

In October, 1939, representatives of petitioner and of the Mutual Benefit Health & Accident Association (hereinafter referred to as "Association") entered into negotiations, at which time they discussed the possibility of petitioner's entering into a contract with Association for the sale of accident policies issued by Association. After continued negotiations, petitioner and Association orally agreed, shortly before December 31, 1939, that petitioner would enter into a contract with Association, to become effective at the expiration of petitioner's contract with Hickey-Mitchell Co. Under the proposed contract, petitioner would start selling Association's policies immediately after February 9, 1940, and would receive commissions of $ 1.15 on each $ 3.50 policy, and 65 cents on each $ 2.50 policy. In addition thereto, petitioner would receive a portion of the profits derived from the sale of such policies equivalent 1950 U.S. Tax Ct. LEXIS 186">*193 to one-half of the difference between 14 T.C. 1021">*1024 75 per cent of the total premium income and the claim loss. Prior to December 31, 1939, Association had the policy forms printed, had employed a claim auditor to commence working in petitioner's office on February 10, 1940, and had filed applications for licenses authorizing petitioner's solicitors to act as its agents in taking applications for insurance. As of December 31, 1939, the necessary approval by the States of Minnesota and Illinois of the policies had not been secured and agents' licenses had not yet been received.

Petitioner first notified its subscribers by a full page advertisement in its January 13, 1940, issue that the accident insurance policies issued by the "Wisconsin Agriculturist and Farmer" would be carried by Association on and after February 10, 1940. The final proof for this advertisement was prepared by petitioner in the latter part of December, 1939, and approved by Association on or about December 30, 1939, and sent to petitioner's print shop on or about January 5, 1940.

On January 23, 1940, petitioner and Association executed an agreement embodying the terms agreed to by the parties under their earlier1950 U.S. Tax Ct. LEXIS 186">*194 oral understanding.

Pursuant to the agreement of January 23, 1940, Association issued, subsequent to February 9, 1940, the two proposed types of accident policies for sale to petitioner's subscribers. These policies had the same premium and were sold by the same solicitors of petitioner to the same class of people as the policies previously handled for National Casualty. Association thereafter maintained in the office of petitioner a claim auditor whose salary, traveling expenses, and other expenses were paid by Association. Settlements of all claims were made by the auditor working under the supervision and direction of the petitioner.

Petitioner's gross income was derived primarily from the advertising carried in the Wisconsin Agriculturist and Farmer. The following schedule reflects the sources of petitioner's gross receipts for the fiscal year ended May 31, 1937, and is typical of each of petitioner's base period years:

Petitioner's1950 U.S. Tax Ct. LEXIS 186">*195 gross receipts from all sources and petitioner's gross commissions from the sale of accident policies to its subscribers for 14 T.C. 1021">*1025 each of the fiscal years ended May 31, 1937, to May 31, 1940, inclusive, were as follows:

During the base period, petitioner did not increase the size of its plant, enlarge its publishing facilities, acquire new publishing facilities, employ additional solicitors, or expand the territory of its publication.

Petitioner's excess profits net income for each of the fiscal years ended May 31, 1937, to May 31, 1940, inclusive, computed without regard to section 722, was in the amount of $ 68,535.27, $ 32,037.33, $ 28,698.50, and $ 31,208.08, respectively. Petitioner's actual average base period net income, 1950 U.S. Tax Ct. LEXIS 186">*196 determined without regard to section 722, was $ 40,119.80.

In its application for relief under section 722, petitioner relied upon section 722 (b) (4) and (b) (5), and stated that there was a change in the character of its business which occurred on January 23, 1940, and in the explanation attached thereto based its claim for relief upon the execution of the agreement with the Mutual Benefit Health & Accident Association of Omaha on January 23, 1940, with a claimed resulting increase in its commissions of 20 cents ³ on each policy, and petitioner's participation in the profits from the sale of the policies.

In this application, petitioner claimed a constructive average base period net income of $ 53,731.72, equivalent to the actual average base period net income of $ 40,199.80, plus the amount of $ 13,611.92. The additional amount of $ 13,611.92 was based upon the asserted increase in the average net insurance1950 U.S. Tax Ct. LEXIS 186">*197 commission income during the fiscal years ended May 31, 1941, to May 31, 1944, inclusive, over the claimed average net insurance commission income during the fiscal years ended May 31, 1937, to May 31, 1940, inclusive. Petitioner concedes that the foregoing computation of a constructive average base period net income in its application for relief under section 722, based upon sales, expenses, and other conditions existing during the fiscal years 1941 to 1944, inclusive, was erroneous.

The total number of accident policies sold by petitioner during the fiscal years ended May 31, 1937, to May 31, 1940, inclusive, and the 14 T.C. 1021">*1026 amount of commissions actually received by petitioner therefrom were as follows:

Of the policies sold during the fiscal year ended May 31, 1940, 2,229 of the $ 2.50 policies and 13,451 of the $ 3.50 policies were sold during the period from June 1, 1939, 1950 U.S. Tax Ct. LEXIS 186">*198 to December 31, 1939, and petitioner's commissions therefrom were in the amount of $ 13,390.12.

Petitioner's books and records reflect the following expenses, all of which relate to petitioner's operations in the sale of accident insurance policies during the fiscal years ended May 31, 1937, to May 31, 1940, inclusive:

The amounts of the foregoing expenses which were incurred during the period from June 1 to December 31, 1939, were as follows: Cancellation charges, $ 83.30; salary of clerk, $ 957; bonus to solicitors, $ 865.67; postage, $ 1,189.13; and printing, $ 287.27.

Petitioner's books and records also reflect the following expenses for the salaries and traveling expenses of petitioner's1950 U.S. Tax Ct. LEXIS 186">*199 solicitors during the fiscal years May 31, 1937, to May 31, 1940, inclusive:

On May 28, 1945, petitioner submitted to respondent a revised computation of constructive base period net income, in which it claimed a constructive average base period net income of $ 50,344.30, or $ 10,224.50 in excess of the actual average base period net income of $ 40,119.80. The increase of $ 10,224.50 was computed by substituting for the net insurance commission income claimed by petitioner to have been actually earned during the fiscal years ended May 31, 1937, to May 31, 1940, inclusive, from the sale of policies issued by the National 14 T.C. 1021">*1027 Casualty Co., a figure representing the net insurance commission income petitioner claims it would have earned by selling the same number of policies during such years under its agreement of January 23, 1940, with the Mutual Benefit Health & Accident Association.

The Commissioner's notice of disallowance dated August 22, 1945, held that:

* * * The1950 U.S. Tax Ct. LEXIS 186">*200 evidence submitted fails to establish that the factor upon which you rely represents a change in the character of the business as contemplated by Section 722 (b) (4). Furthermore, Section 722 (a) precludes the consideration of events or conditions occurring or existing after December 31, 1939 in the determination of a constructive average base period net income, and therefore the event which occurred on January 23, 1940 cannot give use to normal base period earnings, nor cause the actual average base period net income to be an inadequate standard of normal earnings.

During its base period petitioner changed the character of its business and as a result thereof its actual average base period net income did not reflect the normal operation of its business for the entire base period. Petitioner's actual average base period net income is an inadequate standard of normal earnings and its excess profits tax for the fiscal year ended May 31, 1941, computed without the benefit of section 722, results in an excessive and discriminatory tax.

Petitioner's constructive average base period net income for the fiscal year ended May 31, 1941, is the amount of $ 45,000, which represents an increase1950 U.S. Tax Ct. LEXIS 186">*201 of $ 4,880.20 over the actual average base period net income.

OPINION.

In this proceeding, petitioner contests the respondent's disallowance of its claim for relief under section 722 (b) (4) and (b) ( 5) of the Internal Revenue Code. ⁵ Petitioner contends that the substitution of a different contract under which it sold accident policies to its subscribers from and after February 10, 1940, constituted a change in its business operations equivalent to a "change in the character of the business" under section 722 (b) (4), or was a 14 T.C. 1021">*1028 factor which resulted in an inadequate standard of normal earnings during the base period within the meaning of section 722 (b) (5).

1950 U.S. Tax Ct. LEXIS 186">*202 Section 722 (b) (4), in so far as material to the instant case, provides that the excess profits tax imposed 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 provides that "the term 'change in the character of the business' includes a change in the operation * * * of the business * * *."

Initially, the parties raise the issue of whether the petitioner's business operations under the contract of January 23, 1940, consummated with Association were sufficiently different from its operations under its prior contract with the Hickey-Mitchell Co. to constitute a "change in the character of the business" within the meaning of section 722 (b) (4). The question of whether specific events were sufficient to bring about a change in the character of a business has been1950 U.S. Tax Ct. LEXIS 186">*203 considered by this Court in such cases as East Texas Motor Freight Lines, 7 T.C. 579; 7- Up Fort Worth Co., 8 T.C. 52; Lamar Creamery Co., 8 T.C. 928; Irwin B. Schwabe Co., 12 T.C. 606; and Stonhard Co., 13 T.C. 790. However, in none of these cases did we attempt to treat the question as a matter apart from the facts presented in each case. While the statute does not completely define what shall constitute a change in the character of a business, we are willing to accept the general principles outlined in Regulations 112, section 35.722-3 (d), where it is stated:

A change in the character of the business for the purposes of section 722 (b) (4) must be substantial in that the nature of the operations of the business affected by the change is regarded as being essentially different after the change from the nature of such operations prior to the change. No change which businesses in general are accustomed to make in the course of usual or routine operations 14 T.C. 1021">*1029 shall be considered a change in the character of the business1950 U.S. Tax Ct. LEXIS 186">*204 for the purposes of section 722 (b) (4). * * * A change in the character of the business, to be considered substantial, must be reflected in an increased level of earnings which is directly attributable to such change.

The nature or character of a taxpayer's business is at all times subject to many changes which do not necessarily serve to increase the earnings of the business but which in fact may actually result in substantial losses. However, the occurrence of a change in the character of a taxpayer's business for the purposes of securing relief under section 722 is important only if the change directly results in an increase of normal earnings which is not adequately reflected by its average base period net income computed under section 713. It is clear that the critical consideration in granting relief to the taxpayer in such cases as East Texas Motor Freight Lines, 7-Up Fort Worth Co., and Lamar Creamery Co., supra, was the fact that the change was deemed sufficiently important in the taxpayer's business, as reflected by the increase in its earning capacity resulting from the change, to render its average base period net income inadequate1950 U.S. Tax Ct. LEXIS 186">*205 as a standard of normal earnings for the entire base period.

In our opinion, we must regard as a change in the character or nature of a taxpayer's business for the purposes of section 722 (b) (4) any change in the operation of the business that has such a definite and far-reaching effect upon the taxpayer's earning capacity that its actual base period earnings no longer constitute an adequate standard of normal earnings and that results in the tax imposed on that basis being excessive and discriminatory. But this does not mean that a routine change or one which may reasonably be expected to come about in the course of normal business operations meets the test of the statute.

We regard the substitution of contracts whereby petitioner became a direct agent of Association instead of being a subagent for National Casualty as constituting a change in the character of its business within the meaning of the statute. The immediate effect of the change was to give the petitioner an added profit of 20 cents from each policy sold. Moreover, it permitted the petitioner to share in the ultimate profit realized by the insurance company, a feature which was not contained in petitioner's prior1950 U.S. Tax Ct. LEXIS 186">*206 contract with National Casualty. The change was one which was certain to have a far-reaching effect upon petitioner's revenue from insurance sales and was not one which was ordinarily made from year to year in such contracts or could have reasonably been expected to come about in the normal course of business. The record shows that petitioner had dealt with the Hickey-Mitchell Co., as agent of National Casualty, for a 10-year period before obtaining its contract with Association whereby it became the latter's direct representative.

14 T.C. 1021">*1030 Although petitioner primarily operated a publishing business, there can be no doubt that it expected to make a profit from the policies sold, and the record supports petitioner's contention that its revenues from that source constituted a very substantial part of its total net income. From May 31, 1936, through December 31, 1939, petitioner realized an average annual gross income of approximately $ 23,000 from the sale of accident policies. Petitioner's books disclose an average annual expense directly attributable to such sales of approximately $ 6,000, and if a portion of the solicitor's total traveling expenses is allocated to the sale1950 U.S. Tax Ct. LEXIS 186">*207 of accident policies, as we think it should be, an additional expense of $ 5,500 should be added. We have arrived at this figure by giving consideration to the number of subscriptions sold in relation to the number of policies written. The net income from the sale of insurance was therefore approximately $ 11,500, which amount is approximately 28 per cent of petitioner's actual average base period net income of $ 40,119.80 from all sources.

The increase in commission rates and the added right to share equally in the difference between the claim loss and 75 per cent of the total premiums collected provided for in the new contract was certain to result in an immediate and marked increase in the petitioner's net income, as the change in contracts did not involve any additional expenditures on the part of the petitioner. We are therefore convinced that as a result of this change, petitioner's actual average base period net income did not reflect the normal operation for the entire base period of the business and therefore was an inadequate standard within the meaning of the statute, as will more clearly appear from our discussion of petitioner's constructive average base period net1950 U.S. Tax Ct. LEXIS 186">*208 income.

The petitioner's right to relief also depends upon its ability to establish under section 722 (a)⁶ a fair and just amount representing normal earnings to be used as a constructive average base period net income. 14 T.C. 1021">*1031 It is respondent's position that, even if the substitution of contracts is regarded as a change in the character of the business under section 722 (b) (4), such change occurred after December 31, 1939, and therefore under section 722 (a) can not be considered in the determination of a constructive average base period net income.

1950 U.S. Tax Ct. LEXIS 186">*209 The Commissioner's position is best illustrated by the following comments and the example contained in the Bulletin on Section 722, Part VIII, sec. C, pp. 148-149:

The statutory prohibition against regarding post-1939 events relates only to the determination of the constructive average base period net income. It does not affect the ascertainment of the event or factor under section 722 (b) which qualifies the taxpayer for a reconstruction of base period net income, and which may occur at any time during the base period. Consequently, any factors under section 722 (b) (1), (2), (3), (4), or (5), affecting any part of the base period after December 31, 1939, may be considered in determining whether the requirements of section 722 (b) have been met. In making the reconstruction, however, no regard may be had to the actual post-1939 experience of the taxpayer.

* * * *

Assume * * * that a taxpayer with a base period ended November 30, 1940, bases its claim under section 722 (b) (4) on a change in capacity effected during July, 1940, to which it was not committed prior to January 1, 1940. The change in capacity, having occurred during the base period, is a factor which may be considered1950 U.S. Tax Ct. LEXIS 186">*210 under section 722 (b) (4). But in the construction of normal earnings, no regard can be given to the change in capacity because it occurred after December 31, 1939. Consequently, no additional earnings resulting from the changed capacity can be included for any part of the base period. The taxpayer would, therefore, not satisfy the requirements of section 722 and its claim based upon the increased capacity could not be sustained. It will thus be seen that any claim under section 722 (b) (4) based solely upon a change in the character of the business made after December 31, 1939, cannot be allowed. It should be noted, however, that if the change resulted from a commitment made prior to January 1, 1940, the change is deemed to have been made on December 31, 1939, and would not be disqualified. [Italics supplied.]

The petitioner's eligibility for relief under section 722 (b) (4) is initially established by the fact that the change in the character of its business occurred on February 10, 1940, and within its base period which ended May 31, 1940. The statute, in using the term "base period," means the taxpayer's actual base period and not the four calendar years ended December1950 U.S. Tax Ct. LEXIS 186">*211 31, 1939. East Texas Motor Freight Lines, supra.

The statutory purpose of the restrictions incorporated in section 722 (a) was to exclude from consideration in the reconstruction of a taxpayer's average base period net income such events and conditions which were in fact subject to the influence of an abnormal war economy. Congress selected January 1, 1940, as the approximate date when such factors made themselves felt upon the economy. See S. 14 T.C. 1021">*1032 Rept. No. 1631, 77th Cong., 2d sess.; 1942-2 C. B. 504, 649; Fezandie & Sperrle, Inc., 5 T.C. 1185. However, the record shows that petitioner made no changes in its sales organization or physical plant incident to the change in contracts from what it had been during the period from May 31, 1936, through February 9, 1940. The new accident policies were sold to the same subscribers in the same territory, by the same solicitors, and at the same price. The new policies carried the same protection and benefits as the old. There is no evidence that war conditions played any part in the petitioner's substitution of its insurance contracts or the1950 U.S. Tax Ct. LEXIS 186">*212 increased commission rates and profit-sharing privileges it obtained as a result of the change.

Moreover, it was recognized by Congress that certain events would occur in the businesses of taxpayers after December 31, 1939, which could not be arbitrarily classified as arising solely from war conditions and that at least some part of the profits which resulted from such changes might well be regarded as "normal" and not taxable as "excess profits" within the intendment of the statute. Thus, Congress dealt specifically with the so-called "commitment" taxpayer in the last sentence of section 722 (b) (4) and the taxpayer who commenced business after December 31, 1939, in section 722 (c).

In writing the relief provisions of the excess profits statute, Congress gave a broad definition of the various conditions which would qualify a taxpayer for relief and an outline of the basic principles to be followed in the determination of such relief. But the very complexity of the problem necessitated that Congress leave a large measure of administrative discretion to those charged with carrying out its announced policy. It was recognized that the success or failure of the legislation to a considerable1950 U.S. Tax Ct. LEXIS 186">*213 degree depended upon intelligent and sympathetic administration and that the statute should be interpreted to best effectuate the purposes of the legislation. H. Rept. No. 146, 77th Cong., 1st sess.; 1941 C. B. 550, 551.

We do not believe that Congress intended that the general provisions of section 722 (a) relating to the limitation of the use of post-1939 events in the determination of a constructive average base period net income were to be applied in such a manner as to repudiate completely the specific relief authorized by the several subsections of section 722 (b). Therefore, we have concluded that a change in the character of a taxpayer's business occurring during its base period but after December 31, 1939, may be regarded and related to the petitioner's financial experiences and earnings prior to January 1, 1940, in the determination of a constructive average base period net income under the provisions of section 722 (a) as has been done in the instant case.

In our determination of a constructive average base period net 14 T.C. 1021">*1033 income in the amount of $ 45,000, we have used as a basis petitioner's actual average base period net income as stipulated1950 U.S. Tax Ct. LEXIS 186">*214 by the parties, making appropriate adjustments thereto to give effect to the 20-cent increase in commission rates provided for in the new insurance contract. Initially, we determined the petitioner's sales of policies for its entire base period by using figures indicative of petitioner's business during the period from May 31, 1936, to December 31, 1939, and by projecting such figures into 1940 to give recognition to the policies sold during that part of the petitioner's base period from January 1, 1940, through May 31, 1940. The increased commission rate of 20 cents was then applied to the number of policies so determined, resulting in an increase of approximately $ 5,300 in the petitioner's average annual net income. This figure was added to the actual average base period net income of $ 40,119.80, which latter figure we first adjusted to eliminate the income derived under the 20-cent increase in commissions for the period February 10, 1940, through May 31, 1940, which was reflected therein.

In determining a constructive average base period net income, we have refrained from any consideration of the profit-sharing provisions in the new contract, as there is no evidence in the1950 U.S. Tax Ct. LEXIS 186">*215 present record from which we can properly evaluate the effect of these provisions without violating the limitations imposed by section 722 (a) respecting the use of post-1939 events and conditions. We can not accept the petitioner's proposal that we may properly recognize the petitioner's experiences under the profit-sharing plan from February 9, 1940, through December 31, 1942. We have herein determined that a change in the taxpayer's business occurring subsequent to December 31, 1939, but within its base period, may be recognized in so far as eligibility for relief is concerned and may be considered in respect to its effect on petitioner's normal earnings over its entire base period, but in so doing we have not violated the prohibition of section 722 (a) respecting the use of specific financial data such as sales, expenses, profits, etc., occurring after December 31, 1939.

It is our opinion that petitioner has established the right to use a constructive average base period net income in the amount of $ 45,000 in the recomputation of its excess profits tax liability for the fiscal year ended May 31, 1941, and in the determination of the refund in excess profits tax to which it 1950 U.S. Tax Ct. LEXIS 186">*216 is entitled under the provisions of section 722 (b) (4).

In view of our disposition of the issues raised under section 722 (b) (4), it is unnecessary for us to consider the petitioner's eligibility for relief under the provisions of section 722 (b) (5).

Decision will be entered under Rule 50.