situation was "temporary." As in Hummel & Downing Co., supra, 21 T. C., at 236, 238: The earnings of the taxpayer during 1938 and 1939 were unusually low and may fairly be regarded as an inadequate standard of normal earnings. The petitioner has attempted to show that the direct cause of those low earnings was a depression resulting from the temporary overexpansion of kraft pulp capacity or perhaps of the kraft paper board industry. The difficulty of segregating and measuring the effect upon the petitioner's *** 1938 and 1939 earnings of any temporary excess of expanded kraft pulp or kraft liner board capacity from late 1937 to late 1939 over the expanded production of or demand for those products during that same period is obvious. * * * The petitioner, in making those computations, has made too many assumptions too favorable to itself *** For all that appears from the present record, prices would have remained low-and in fact might well have been the economic cause for increased consumption. Only greater efficiency and lower costs of production and operation could save an industry in such a predicament. And these expedients, the record shows, were being successfully employed by petitioner to save its economic life as the base period. came to a close. For those changes, to the extent permissible, we are giving petitioner credit in the reconstruction. The correct analysis seems to be that the general business depression, coupled simultaneously with great increases in capacity in petitioner's industry, caused a drop in prices which, except for the war, would have been neither temporary nor unusual; and that the highly profitable operations previously carried on by petitioner and its competitors were the occasion, under our economic system, first for new entrants into the field and then for resort to greater efficiency on the part of all. This is to be expected in our economy and neither a mere period of depression, Industrial Yarn Corporation, supra, nor intense competition, Harlan Bourbon & Wine Co., 14 T. C. 97; Winter Paper Stock Co., 14 T. C. 1312; Lamar Creamery Co., 8 T. C. 928, qualifies petitioner for relief under section 722. In this view it becomes unnecessary to decide whether, as petitioner contends, the southern kraft producers were a separate industry. Neither such industry, if any, nor petitioner has been shown to be the victim of temporary or unusual economic events or circumstances. III. Increased Capacity Under 722 (b) (4). We have found as an ultimate fact that petitioner has failed to establish an increased capacity for production during the base period as a ground for relief within the meaning of section 722 (b) (4). As far as the installation of Sutherland refiners is concerned, the evidence does not sustain petitioner's contention that it increased petitioner's capacity to produce during the base period. If we grant petitioner's contention that Capacity for production appears to be the ability of a given plant to produce that which it is designed to create or produce and is expressed in terms of the number of units manufactured, created or produced in a given period. *** We see nothing different in principle in the question before us and believe that "capacity for production" in the statute we now interpret means mere "average producing capacity in a given time," that is, actual ability to produce within a given time. * * [Jacob's Fork Pocahontas Coal Co., 17 T. C. 357, 363. Emphasis added.] and, further, that the removal of an internal bottleneck within a plant such as its paper mill might bring about a qualifying increase in plant capacity even though the capacity of the ultimate board and paper machines remained the same, by permitting those machines to realize more of their output potential than had previously been possible, still the evidence does not support petitioner's assertion that the installation of the Sutherlands achieved this purpose. It is true that by 1939 all of the Sutherlands had been installed and the period was one which petitioner itself contends to be "normal" as a measure of production after all of its alleged changes in the character of its business, even without the benefit of the "push-back rule." It is also true that its total board production then exceeded that of 1936 and 1937. But closer analysis reveals that this increase was due almost entirely to petitioner's operation of its machines for a greater number of machine days during 1939 than in the prior years. On 1 of its 4 paper making machines, for example, its average production per machine day during 1939 was only a fraction of a ton (about 0.63 per cent) more than its average daily production in 1937, when installation of the Sutherland refiners was still in its initial stage.10 Another comparison for this machine, by months in each of the base period years during which it was operated the most machine days, again discloses almost no variation in average daily production throughout the base period." The evidence indicates that another paper machine averaged a greater daily production during some months in 1936 than in 1939. And the only substantial increase in production on the 2 remaining machines occurred between 1936 and 1937, an increase which we have 10 Machine #3: 1937: 305.2 machine days operated; average daily production, 138.58 tons. 1939: 320.9 machine days operated; average daily production, 139.45 tons. Sutherland pulp refiners were not installed in front of this machine until November 1937. found to be attributable directly to the installation of additional drying capacity on these machines rather than to an increased quantity of pulp supplied by the Sutherlands, which were not put into fulltime use in front of these machines prior to that time. Finally, we are satisfied that any slight increase in average producing capacity indicated by the output of the paper machines in 1939 is attributable either to such routine improvements as the increased drying capacity and other changes which petitioner does not urge as constituting a change in the character of its business within the meaning of section 722 (b) (4), or to the substantial changeover in 1939 from paper to board production, considered in the light of our finding that these machines were able to produce substantially more board than paper from kraft pulp within the same period of time. In view of these other circumstances, petitioner cannot be held to have sustained its burden of proving that the Sutherlands were capable of refining more pulp in a given time than did the Miami Jordan refiners, regardless of any improvements in the quality of the pulp. When these circumstances are combined with a statement made by petitioner's own counsel in 1944 in connection with another proceeding involving petitioner's president, in which he wrote that "the Brown Paper Mill's capacity remained approximately the same" from 1932 through 1941, according to statistical data which he alleged to be "recognized authority," we conclude that petitioner has not sustained its burden of proving qualification on the basis of any increased plant capacity which may be traced directly and specifically to the Sutherland refiners. To the extent that the claim of increased capacity is based on the installation of the McDonald dehydrators, it was not adequately raised. or claimed prior to these proceedings, either in the original claims for relief or in the conference memoranda in support thereof. Claims and evidence dealing with the McDonalds were concerned solely with their effect as a change in method of operation in decreasing petitioner's costs of production. We may not consider them as a source of increased capacity for production for the first time in the Tax Court. Blum Folding Paper Box Co., 4 T. C. 795; Wadley Co., 17 T. C. 269. IV. Changes in Method of Operation Under 722 (b) (4). We are satisfied, however, that both the McDonalds and the Sutherlands constituted changes in petitioner's method of operation within the meaning of section 722 (b) (4), and warrant a reconstruction of its net earnings on the basis of savings which would have resulted had petitioner's actual production been achieved at the lower power and chemical costs and other savings which would have been possible had these installations occurred earlier. These were not mere rou tine changes, such as were the increases in drying capacity. Nor were they mere improvements of older equipment or ordinary technological improvements developed to perform the same functions in the same manner, although at greater economic efficiency. Cf. Suburban Transportation System, 14 T. C. 823. The record clearly establishes that both the McDonalds and the Sutherlands were "substantially different processes of manufacturing" within the contemplation of section 722 (b) (4) and Regulations 112, section 35.722–3 (d) (1). Having rejected petitioner's claim of increased capacity, the reconstruction of cost savings has been, of course, modified to the extent that it was originally measured by petitioner's proposed reconstructed production. V. Reconstruction. After a careful consideration of the entire record and all facts and circumstances relevant to the extent of petitioner's qualification for relief under section 722 (b) (4), and applying the principle of Cohan v. Commissioner, (C. A. 2) 39 F. 2d 540, where the record has so required, see National Grinding Wheel Co., 8 T. C. 1278, MorrowThomas Hardware Co., 22 T. C. 781, we have concluded that the evidence justifies the reconstruction of additions to petitioner's actual net income for each of the base period years to the extent indicated in our findings of fact, see Lily Mills Co., 21 T. C. 900, Radio Shack Corporation, 19 T. C. 756, amounts which are in excess of the adjustments previously granted by respondent 12 under section 713 (e). No adjustment for change in capital ratio may be permitted as an increase in the credit for the year 1940, however, in view of our conclusion that petitioner did not make timely application for relief based on this ground for that year. Petitioner concedes that an adjustment will have to be made for its State income taxes during the base period years. It asserts that "this can be adjusted under a Rule 50 computation," apparently from figures already in evidence. Respondent challenges neither the propriety of such an adjustment in the event of some reconstruction, such as we shall in fact allow, nor the assumption that the record contains sufficient material to permit this adjustment to be accomplished in a recomputation. Any such adjustment in the constructive average base period net income may accordingly be left to the Rule 50 computation. Issues Other Than Those Under Section 722. I. Originally petitioner deducted in full as current business expense, during the base period years, the payments made for the Sutherland 12 See footnote 2, supra. refiners which it leased under its contracts with Sutherland. It now seeks to treat these amounts as capital expenditures and to restore the deductions to base period income, while granting respondent's right to readjust its base period years income taxes under section 734 13 because of this inconsistency. The parties have agreed upon proper rates of depreciation for both base period years and the taxable years in controversy in the event that petitioner's contention is upheld. Granting that as to Sutherland the receipts in excess of cost were income, we cannot say that petitioner was mistaken in its original treatment of the payments from its own tax and accounting standpoints. Under the contracts, all it was assured of was the use of the machines for 1 year. It had not taken and was not taking title to the property within the purview of section 23 (a). As in International Cigar Machinery Co., 36 B. T. A. 124, 140, We do not intend to hold that the method of accounting used by the petitioner is the only correct one, But since in that case, on similar facts involving a lessor, there was testimony *** by well qualified accounting experts that it might have been proper [for the lessor] to treat the lump sum payments as deferred income spread over the life of the contracts and to deduct an equivalent amount annually for depreciation of the machines * * we are unwilling to say that, as lessee, petitioner erred in treating the payments as current expenses and not capital outlays. In a proceeding in which Sutherland was the petitioner we decided in a Memorandum Opinion that payments made by petitioner for the 13 Internal Revenue Code of 1939. SEC. 734. ADJUSTMENT IN CASE OF POSITION INCONSISTENT WITH PRIOR (b) CIRCUMSTANCES OF ADJUSTMENT. (1) If (A) in determining at any time the tax of a taxpayer under this subchapter an item affecting the determination of the excess profits credit is treated in a manner inconsistent with the treatment accorded such item in the determination of the income-tax liability of such taxpayer or a predecessor for a prior taxable year or years, and (B) the treatment of such item in the prior taxable year or years consistently with the determination under this subchapter would effect an increase or decrease in the amount of the income taxes previously determined for such taxable year or years, and (C) on the date of such determination of the tax under this subchapter correction of the effect of the inconsistent treatment in any one or more of the prior taxable years is prevented (except for the provisions of section 3801) by the operation of any law or rule of law (other than section 3761, relating to compromises), then the correction shall be made by an adjustment under this seection. *** (2) Such adjustment shall be made only if there is adopted in the determination a position maintained by the Commissioner (in case the net effect of the adjustment would be a decrease in the income taxes previously determined for such year or years) or by the taxpayer with respect to whom the determination is made (in case the net effect of the adjustment would be an increase in the income taxes previously determined for such year or years) which position is inconsistent with the treatment accorded such item in the prior taxable year or years which was not correct under the law applicable to such year. |