Opinion
Docket No. 18501.
1950-06-28
WINTER PAPER STOCK COMPANY, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Edward M. Kovachy, Esq., and Evelyn P. Kovachy, Esq., for the petitioner. Lawrence R. Bloomenthal, Esq., for the respondent.
Petitioner, a waste paper dealer in Cleveland, seeks relief under section 722(b)(2) of the Internal Revenue Code, from excess profits tax for 1943 on the ground that its base period earnings were depressed because of a price war. Held, petitioner is not entitled to relief, as it has not established that its average base period net income is an inadequate standard of normal earnings, or that its business or the industry of which it is a member was depressed on account of temporary economic events unusual in the case of such industry. Edward M. Kovachy, Esq., and Evelyn P. Kovachy, Esq., for the petitioner. Lawrence R. Bloomenthal, Esq., for the respondent.
This proceeding is for review of the respondent's disallowance of petitioner's application for excess profits tax relief under section 722 of the Internal Revenue Code, as amended, for the taxable year ended December 31, 1943. The petitioner filed an application for relief in which it requested an increase in the excess profits credit through the determination of a constructive average base period income.
The respondent rejected the application for relief and disallowed a claim for refund asserted in the application for relief. The same letter also gave petitioner formal notice of certain final adjustments in its declared value excess profits tax and its excess profits tax for 1943 which resulted in deficiencies of $2.07 and $12,719.85, respectively.
The petitioner does not contest the determinations which resulted in the above deficiencies and confines its assignment of error to the disallowance of its claim for relief under section 722. However, in so doing, the petitioner claims a refund of excess profits tax for 1943 in the amount of $32,389.59.
The only question is whether the respondent erred in disallowing the petitioner's application for relief under section 722(b)(2).
Petitioner filed its income and excess profits tax returns for the year 1943 with the collector for the eighteenth district of Ohio, in Cleveland.
The record in this proceeding consists of a stipulation of facts, testimony, and exhibits, from which we make the following findings of fact.
FINDINGS OF FACT.
The stipulated facts are found as stipulated and are incorporated herein as part of the findings of fact by this reference.
Petitioner is a corporation, organized under the laws of the State of Ohio, with its principal office and place of business in Cleveland, Ohio. It is engaged in the business of collecting, grading, and packing waste paper, which it, in turn, sells to boxboard and other paper mills. The waste paper is collected by a fleet of trucks and brought into the plant, where it is sorted and cleaned in an operation which separates the various kinds and grades of paper. The more valuable grades are segregated and packed separately. The end product of this operation is known as ‘mixed paper,‘ which goes through a separate cleaning operation, after which it is hydraulically pressed into large bales weighing up to a ton and then shipped to paper mills which use it as raw material in the manufacture of new paper.
Petitioner buys its waste paper from department stores, office buildings, printing house, schools, Boy Scout troops, and various industries in the Cleveland area. The purchase price of the waste paper is determined by a number of factors, including the amount of paper, cost of collecting, the cleanliness and grade of the paper, and the price paid by the paper mills for the waste paper.
The gross profit, operating costs, and net operating profit per ton on paper handled by the Winter Paper Stock Co., exclusive of brokerage, during the years 1925 through 1939 were as follows:
+-----+ ¦¦¦¦¦¦¦ +-----+
Per ton
Calendar year Other Net operating
Gross Labor operating profit Tons profit cost costs or (loss) handled 1925 $6.99 $2.70 $3.21 $1.08 10,351 1926 7.75 2.99 3.12 1.64 12,001 1927 6.63 2.30 2.97 1.36 14,277 1928 7.47 2.53 3.27 1.67 13,436 Averages 7.21 2.63 3.14 1.44 12,516 1929 4.82 2.49 2.70 (.37) 14,617 1930 4.33 1.93 2.43 (.03) 15,516 1931 3.93 2.11 2.64 (.82) 14,389 1932 2.77 1.30 2.76 (1.29) 12,547 1933 3.96 1.60 2.79 (.43) 10,065 1934 4.25 2.68 3.63 (2.06) 8,125 1935 4.02 1.92 2.35 (.25) 10,675 Averages 4.01 2.00 2.76 (.75) 12,276 1936 5.68 2.30 2.67 .71 10,075 1937 5.84 2.56 2.54 .74 11,235 1938 4.42 2.22 2.38 (.18) 11,950 1939 3.89 1.99 1.98 (.08) 14,025 Averages 4.96 2.27 2.39 .30 11,821
Petitioner also carries on extensive operations as a broker of waste paper. In its brokerage transactions, petitioner pays the vendor approximately 95 percent of the net price which petitioner receives for the waste paper from the paper mills. This paper is never delivered to or processed in the plant of petitioner, but is shipped directly to the mills by the vendor. Petitioner realizes an estimated gross profit of 5 percent on brokerage sales, from which estimated other costs of 2 1/2 percent of the net brokerage sales are deducted, resulting an estimated net profit on brokerage sales of 2 1/2 percent. The net brokerage sales, estimated gross profit and net profit, tons sold, average sales price per ton, and percentage which brokerage sales bore to total sales for the years 1925 through 1939 were as follows:
+------+ ¦¦¦¦¦¦¦¦ +------+
Estimated Average Percentage Year Net sales Tons sales of brokerage Gross Net profit per ton sales to profit price total sales
Percent 1925 $79,319.81 $3,776.95 $1,888.48 4,993 $15.89 27.95 1926 74,291.79 3,537.50 1,768.75 4,771 15.57 26.28 1927 84,661.10 4,031.22 2,015.61 5,986 14.14 25.97 1928 123,355.36 5,874.06 2,937.03 7,804 15.81 33.46 Averages, 4 years 90,407.01 4,304.93 2,152.47 5,888 15.35 28.42 1929 98,822.39 4,705.82 2,352.91 6,736 14.67 27.98 1930 76,564.89 3,645.93 1,822.97 8,034 9.53 30.59 1931 116,914.11 5,567.44 2,783.72 12,686 9.22 45.27 1932 42,541.77 2,025.58 1,012.79 5,865 7.25 30.37 1933 97,187.32 4,628.27 2,314.13 7,148 13.60 44.38 1934 51,456.10 2,450.38 1,225.19 5,462 9.42 38.32 1935 40,505.98 1,928.84 964.84 4,593 8.82 29.04 Averages, 7 years 74,856.08 3,564.61 1,782.30 7,218 10.37 35.13 1936 68,556.99 3,264.61 1,632.31 6,055 11.32 34.14 1937 165,016.19 7,858.09 3,929.04 11,985 13.76 47.78 1938 62,285.11 2,966.06 1,483.03 8,462 7.40 36.71 1939 111,604.56 5,314.50 2,657.25 10,770 10.78 41.87 Averages, 4 years 101,865.71 4,850.82 2,425.41 9,318 10.93 40.13
Petitioner's sales to the paper mills during the base period years consisted of approximately 50 percent mixed paper, 20 percent newspaper, 20 percent corrugated paper, and 10 percent high grade paper, including krafts, ledgers, and magazines. Because of the high freight rates, the principal customers for the waste paper collected by petitioner during the base period years were various paper mills located within a 300-mile radius of Cleveland, including the Ohio Boxboard Co., at Rittman, Ohio; the United States Gypsum Co., Gypsum, Ohio; the Geiger-Richardson Co., at Middletown and Lockland, Ohio; the Kalamazoo Paper Co. and the Allied Mills, at Kalamazoo, Michigan; and the Consolidated Paper Co. and the River Raisin Paper Co., at Monroe Michigan. During the base period years, as well as for a number of years prior thereto, the prices paid by the paper mills for waste paper were determined in advance for a period of one month. The various mills execute purchase orders on or about the first of each month, stating the quantities of the various grades of paper that they would buy during that month and the price that they would pay for each grade shipped to them in that month. With the knowledge of the selling prices at the beginning of the month, the normal practice is for the waste paper dealer to adjust his buying prices so as to recover his costs and realize a profit per ton of paper handled.
The average cost per hundredweight of waste paper purchased by the petitioner during the years 1925 through 1939 was as follows:
+------------------------------+ ¦ ¦Including ¦ ¦ +----+------------+------------¦ ¦Year¦brokerage ¦Exclusive of¦ +----+------------+------------¦ ¦ ¦transactions¦brokerage ¦ +----+------------+------------¦ ¦1925¦$0.65 ¦$0.63 ¦ +----+------------+------------¦ ¦1926¦.54 ¦.48 ¦ +----+------------+------------¦ ¦1927¦.53 ¦.51 ¦ +----+------------+------------¦ ¦1928¦.61 ¦.53 ¦ +----+------------+------------¦ ¦1929¦.64 ¦.61 ¦ +----+------------+------------¦ ¦1930¦.37 ¦.32 ¦ +----+------------+------------¦ ¦1931¦.36 ¦.30 ¦ +----+------------+------------¦ ¦1932¦.26 ¦.24 ¦ +----+------------+------------¦ ¦1933¦.46 ¦.40 ¦ +----+------------+------------¦ ¦1934¦.33 ¦.29 ¦ +----+------------+------------¦ ¦1935¦.31 ¦.26 ¦ +----+------------+------------¦ ¦1936¦.42 ¦.37 ¦ +----+------------+------------¦ ¦1937¦.58 ¦.50 ¦ +----+------------+------------¦ ¦1938¦.27 ¦.23 ¦ +----+------------+------------¦ ¦1939¦.42 ¦.37 ¦ +------------------------------+
The price paid by the paper mills for waste paper was fairly uniform through the middle western part of the United States. However, the price offered by the paper mills for paper stock and the prices paid by waste paper mills for paper stock and the prices paid by waste paper dealers to their sources of supply fluctuated widely from month to month and year to year during the base period and for many years prior thereto.
It is customary in the waste paper business to institute a service charge when the price paid by the mills for the paper stock falls below the cost of operations. However, despite the fluctuations of the mill prices during the base period years, no service charge for picking up the paper was made to its suppliers by petitioner. The purchase of paper from the sources of supply ordinarily was handled on a monthly basis, although a small portion of petitioner's business was under contracts which gave a standing order for a six-month period. While the department stores and office buildings have to get rid of their waste paper every day, they expect to be paid for it and will deal with whichever firm offers the best price and service.
Petitioner's net sales including brokerage, gross profit, and net income or loss for the years 1923 through 1939 were as follows:
+----+ ¦¦¦¦¦¦ +----+
Net sales, Year including Gross profit Gross profit Net income brokerage or (loss)
Per cent 1923 $232,943.15 $42,602.37 18.29 ($11,047.51) 1924 248,341.84 52,894.01 21.30 (387.89) 1925 283,774.78 76,140.43 26.84 11,055.82 1926 282,738.72 96,525.92 34.13 18,018.84 1927 325,937.45 98,612.16 30.25 19,026.17 1928 368,713.73 106,229.57 28.81 23,827.65 1929 353,173.23 75,138.13 21.28 (3,636.94) 1930 250,262.09 70,790.03 28.30 1,348.54 1931 258,264.81 62,167.42 24.08 (13,226.74) 1932 140,087.71 36,765.52 26.25 (15,198.22) 1933 218,979.99 44,475.55 20.31 (5,929.96) 1934 134,293.72 37,012.56 27.56 (16,273.32) 1935 139,469.67 44,802.64 32.12 (2,449.11) 1936 200,840.02 60,417.88 30.08 7,722.86 1937 345,396.88 73,427.30 21.26 9,886.30 1938 169,665.29 55,840.84 32.91 (3,059.20) 1939 266,556.37 59,816.29 22.44 (1,372.16)
A competitor entering the waste paper business on a large scale in Cleveland from 1925 through 1939 could succeed only be developing adequate sources of waste paper. Accounts could be obtained by a new firm only by offering more money for waste paper than was being paid by established concerns. To maintain and protect their own business the established dealers would be forced to meet the price offered by a new competitor.
The National Waste Material Co. (hereinafter referred to as ‘National) entered the waste paper business in Cleveland in April, 1925, and continued in active operation until 1940, when it sold out to another company. During that period there were at least 60 or 70 other companies which were engaged in handling waste materials, such as rags, iron, bottles, and paper. Petitioner and National, however, were among the few concerns dealing exclusively in waste paper. During the years 1926 to 1939 National was the only new competitor to enter the waste paper business in Cleveland. National was owned in approximately equal shares by R. W. Joyce and his wife and by one Shapiro and his wife.
On November 22, 1932, R. W. Joyce, president of National, was convicted on charges of violating the Interstate Commerce Commission Act and was fined $1,500 by the United States District Court. He believed that petitioner and other members of the waste paper industry in Cleveland were responsible for his indictment and conviction. While the Federal criminal case against Joyce was pending, National filed a petition in the Common Pleas Court of Cuyahoga County, Ohio, charging that petitioner and ten other concerns had violated the Ohio antitrust laws, sections 6390 to 6400 of the Ohio General Code, by conspiring to interfere and by interfering with National's business. This action never came to trial, but was settled in 1939. Soon thereafter National sold out to the Co Waste Paper Co.
During the base period years 1936 to 1939, Joyce bore a grudge against the petitioner and other members of the waste paper industry in Cleveland because he believed they were responsible for his indictment and conviction on charges of violating the Interstate Commerce Commission Act. During this period Joyce instructed his solicitors to obtain as many accounts of National's competitors as they could and told them that they could pay the suppliers as much as the mills would pay to National for the paper. National offered the ordinary price to its own customers, but would offer much higher prices to its competitors' customers by means of cards, letters, and telephone calls. Some of these cards were shown to National's customers by its competitors to prove that National was engaged in double dealing. Since the waste paper business is built on good service and fair and honest treatment of suppliers, National acquired a very poor name in the trade. Many sources of supply which maintained regular salvage departments became suspicious when they were offered as much for their waste paper as could be gotten for it from the mills. They felt that National might not be good for the money or that it did not give correct weights. Consequently, many of the suppliers, refused to give their business to National. The net effect of National's policy of offering higher prices to its competitors' customers than to its own was to discredit it in the Cleveland area, causing it to lose tonnage during each of the years of the base period. During those same years the average tonnage purchased by petitioner increased.
The following schedule shows the amount by which the tonnage of paper purchased by the petitioner fluctuated from year to year during the period 1925 to 1939, inclusive:
+----------------------------------------------------------+ ¦ ¦Tons ¦ ¦ ¦ ¦ +--------------+---------------+----------+---------+------¦ ¦Calendar year ¦increase or ¦Total tons¦ ¦ ¦ +--------------+---------------+----------+---------+------¦ ¦ ¦(decrease) over¦purchased ¦Brokerage¦Other ¦ +--------------+---------------+----------+---------+------¦ ¦ ¦prior year ¦ ¦ ¦ ¦ +--------------+---------------+----------+---------+------¦ ¦1925 ¦2,792 ¦15,248 ¦4,993 ¦10,255¦ +--------------+---------------+----------+---------+------¦ ¦1926 ¦1,531 ¦16,779 ¦4,771 ¦12,008¦ +--------------+---------------+----------+---------+------¦ ¦1927 ¦3,338 ¦20,117 ¦5,986 ¦14,131¦ +--------------+---------------+----------+---------+------¦ ¦1928 ¦1,168 ¦21,285 ¦7,804 ¦13,481¦ +--------------+---------------+----------+---------+------¦ ¦Total, 4 years¦ ¦73,429 ¦23,554 ¦49,875¦ +--------------+---------------+----------+---------+------¦ ¦1929 ¦847 ¦22,132 ¦6,736 ¦15,396¦ +--------------+---------------+----------+---------+------¦ ¦1930 ¦908 ¦23,040 ¦8,034 ¦15,006¦ +--------------+---------------+----------+---------+------¦ ¦1931 ¦4,986 ¦28,026 ¦12,686 ¦15,340¦ +--------------+---------------+----------+---------+------¦ ¦1932 ¦(10,068) ¦17,958 ¦5,865 ¦12,093¦ +--------------+---------------+----------+---------+------¦ ¦1933 ¦(18) ¦17,940 ¦7,148 ¦10,792¦ +--------------+---------------+----------+---------+------¦ ¦1934 ¦(3,263) ¦14,677 ¦5,462 ¦9,215 ¦ +--------------+---------------+----------+---------+------¦ ¦1935 ¦(1,552) ¦13,125 ¦4,593 ¦8,532 ¦ +--------------+---------------+----------+---------+------¦ ¦Total, 7 years¦ ¦136,898 ¦50,524 ¦86,374¦ +--------------+---------------+----------+---------+------¦ ¦1936 ¦2,814 ¦15,939 ¦6,055 ¦9,884 ¦ +--------------+---------------+----------+---------+------¦ ¦1937 ¦8,225 ¦23,154 ¦11,985 ¦11,169¦ +--------------+---------------+----------+---------+------¦ ¦1938 ¦(2,502) ¦20,652 ¦8,462 ¦12,190¦ +--------------+---------------+----------+---------+------¦ ¦1939 ¦3,802 ¦24,454 ¦10,770 ¦13,684¦ +--------------+---------------+----------+---------+------¦ ¦Total, 4 years¦ ¦84,199 ¦37,272 ¦46,927¦ +--------------+---------------+----------+---------+------¦ ¦Averages: ¦ ¦ ¦ ¦ ¦ +--------------+---------------+----------+---------+------¦ ¦1925-28 ¦ ¦18,357 ¦5,888 ¦12,469¦ +--------------+---------------+----------+---------+------¦ ¦1929-35 ¦ ¦19,557 ¦7,218 ¦12,339¦ +--------------+---------------+----------+---------+------¦ ¦1936-39 ¦ ¦21,050 ¦9,318 ¦11,732¦ +----------------------------------------------------------+
Petitioner's average base period net income does not constitute an inadequate standard of its normal earnings within the meaning of section 722. Petitioner's business was not depressed in the base period because of temporary economic circumstances, unusual in the case of petitioner, or because of temporary economic events unusual in the industry of which petitioner was a member.
Petitioner is not entitled to excess profits tax relief under section 722(b)(2).
OPINION.
HARRON, Judge:
The only question in this proceeding is whether the respondent erred in disallowing petitioner's application for excess profits tax relief under the provisions of section 722 of the Internal Revenue Code. If the petitioner establishes that the tax computed without benefit of this section ‘results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income,‘ then it must prevail. Sec. 722(a). The petitioner relies upon section 722(b)(2), under which the tax computed without benefit of section 722 shall be considered to be excessive and discriminatory if the taxpayer's average base period net income is an inadequate standard of normal earnings because:
(2) The business of the taxpayer was depressed in the base period because of temporary economic circumstances unusual in the case of such taxpayer or because of the fact that an industry of which such taxpayer was a member was depressed by reason of temporary economic events unusual in the case of such industry.
Petitioner does not take the position that the industry of which it was a member was depressed during the base period years. But it does contend that its own business was depressed during those years, with the result that its average base period net income is an inadequate standard of normal earnings.
We do not believe, however, that the petitioner has shown that its average base period net income was an inadequate standard of normal earnings. During the base period years 1936 and 1937, petitioner had net operating profits, exclusive of brokerage income, for the first time since 1928. In 1938 and 1939 it had net operating losses, exclusive of brokerage sales, which were substantially lower than the losses for any of the years since 1928, with the exception of the year 1930. Its average net operating profit per ton handled, exclusive of brokerage, during the base period was 29.75 cents, although in the seven prior years it had an average net loss per ton of 75 cents. During the base period years petitioner had an average net profit on brokerage sales of $2,425.41 on an average of 9,318 tons handles as broker. This compared favorably with the average net profit on brokerage sales of $2,152.47 from 1925 through 1928 on an average of 5,888 tons handled and $1,782.30 average net profit on brokerage sales from 1929 through 1935 on an average of 7,218 tons handled.
The lower prices paid for waste paper by the mills in the base period years account for the fact that the estimated average net profit on brokerage sales increased only 12.68 percent over that of the years 1925 through 1928, although there was an increase of 58.24 percent in the brokerage tons handled in the base period over 1925 through 1928. In any comparison between the base period and the years 1925 through 1928, it is significant to note that the percentage of brokerage sales to total sales increased 41.20 percent in the base period over 1925 through 1928, from 28.42 percent of net sales to 40.13 percent. However, the average sale price per ton, upon which an estimated net profit of 2 1/2 percent was made for both periods, decreased 28.79 percent, from $15.35 per ton to $10.93 per ton.
Petitioner relies principally upon the contention that a price war existed in the base period years among the firm including petitioner, which collected and processed waste paper in Cleveland. Regulations 112, section 35.722-3(b), recognizes that a ruinous price war may be a temporary economic circumstance unusual in the case of a taxpayer and may constitute a basis for relief under section 722(b)(2). But active competition is a normal factor in business and can not be considered temporary or unusual. Lamar Creamery Co., 8 T.C. 928, 939; Monarch Cap Screw & Manufacturing Co., 5 T.C. 1220, 1230. And the evidence as a whole fails to show that the conditions under which the waste paper industry operated in Cleveland during the base period were either temporary or unusual.
The waste paper industry differs from most other businesses in that competition in it lies primarily in the prices which are paid to the sources of waste paper, such as department stores, office buildings, printing houses, and various industries. This is because high handling costs limit the sources of supply to those which accumulate large amounts of waste paper over a relatively short period of time. A firm entering the waste paper business in Cleveland from 1925 through 1939 could succeed only by developing adequate sources of waste paper. Only by offering higher prices for waste paper could a new concern take away from the established businesses the accounts of suppliers of waste paper. Similarly, an existing concern desirous of increasing its share of the market could do so only by increasing the prices which it was willing to offer the suppliers.
It may very well be that the policy adopted by National forced petitioner to pay prices for waste paper in excess of prices which might otherwise have obtained. But the raising of petitioner's costs by the activities of National was not the result of a price war; it was the result of the intense competition instigated by National among the waste paper dealers in Cleveland. Cf. Harlan Bourbon & Wine Co., 14 T.C. 97. National's reasons for fomenting this competition are unimportant. The evidence does not show that National, through the payment of excessively high prices for waste paper, had embarked on a policy of destroying the industry in Cleveland because of certain real or imagined wrongs suffered by its president and general manager. National was interested in making a profit. It was also desirous of increasing its share of the market at the expense of its competitors. In furtherance of this policy, it embarked on a program of intense price competition. But once it had succeeded in taking away an account from one of its competitors through the payment of higher prices, it would shortly thereafter reduce the price to a point where it could make a profit on it. The net effect of National's policy, however, was to antagonize its regular sources of supply, who were not paid the higher prices offered potential customers, and the number of tons of waste paper handled by National decreased steadily during the base period. During those same years, the number of tons handled by petitioner increased.
Petitioner contends that the alleged price war had been in effect since 1929.
It is difficult to see how conditions under which an industry, or a segment of an industry, has been operating for 11 years can be characterized as temporary and unusual. And unless the economic circumstances under which the petitioner operated were temporary and unusual, it is not entitled to relief under section 722(b)(2). The price practices among the waste paper dealers in Cleveland were part of the economic climate in which petitioner operated from 1929 until 1940. The evidence shows that the intensively severe price competition was a regular and expected occurrence in Cleveland during those years; that it was not temporary and unusual.
The exact date at which National began the keen price competition is not clear from the evidence. Petitioner claims that the alleged price war was instigated by the president of National out of malice arising from his conviction of violation of the Interstate Commerce Act, for which he believed his competitors responsible. If this was the motivating factor, it is interesting to note that National's president was not indicted until March 1932, and not convicted until November 1932. And a comparison of petitioner's activities from 1929 through 1932 with its activities in the base period shows that its operations were much more profitable during the base period years. Petitioner had a net loss of $3,636.94 in 1929, a net income of $1,348.54 in 1930, a net loss of $13,226.74 in 1931, and a net loss of $15,198.22 in 1932. In the base period years, petitioner had a net income of $7,722.86 in 1936, a net income of $9,886.30 in 1937, a net loss of $3,059.20 in 1938, and a net loss of $1,372.16 in 1939.
We can not conclude from the evidence that the petitioner has established that its average base period net income is an inadequate standard of normal earnings because its business was depressed during the base period years due to a temporary economic circumstance, unusual in its case, namely, a ruinous price war. It is held, therefore, that respondent was correct in refusing to allow petitioner's claim for relief under section 722(b)(2).
Reviewed by the Special Division.
Decision will be entered for the respondent.