Beringer Bros., Inc. v. Commissioner ( 1952 )

Beringer Bros., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Beringer Bros., Inc. v. Commissioner

Docket No. 26211

United States Tax Court

18 T.C. 615; 1952 U.S. Tax Ct. LEXIS 157;

June 24, 1952, Promulgated

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Decision will be entered under Rule 50.

1. Petitioner, since its organization in 1914 and as the successor of a partnership organized in 1876, has engaged in the business of making fine wines. Its standing in the trade has been based chiefly on its old wines which were blends of wines which had been aged two years or more. During prohibition, it produced and sold sacramental wines and at repeal had some substantial inventory of old wines. It sought to keep pace with the wine business generally and at the same time maintain a proper inventory of aged wines for blending and sale from year to year, and to that end, in 1935 began the expansion of its storage facilities by 200,000 gallons. In keeping with current demands, it began selling its new production in increased quantities and for that reason did not store and age sufficient quantities of wines from year to year to maintain its inventory of aged wines at the level required and needed. It was not financially able to expand its storage capacity further. It was apparent by 1937 that it would have to curtail its sales if its production of aged wines was to be maintained. In 1937, it began working under an arrangement with a nearby winery, whereby its winemaster supervised the cleaning up of the winery for the storing and aging of fine wines, supervised the making, storing and aging of the wines, and in return petitioner acquired the right to purchase the wines so made and aged at the current market price or at the best price which might be obtained therefor from an outside party. Petitioner's business did not, by the end of the base period, reach the earning level which it would have reached if it had started working under the arrangement with the nearby winery in 1935, instead of 1937. Held, that the making of the arrangement with the nearby winery and the operations thereunder, beginning in 1937, constituted a change in the character of petitioner's business within the meaning of section 722 (b) (4) of the Internal Revenue Code. The fair and just amount representing normal earnings to be used as a constructive average base period wine net income determined.

2. Petitioner in 1937 began the production of commercial or beverage brandy, which was to it a new product. The respondent allowed petitioner's claim for relief under section 722 (b) (4) on the ground that the beginning of the production of beverage brandy constituted a change in the character of petitioner's business. He determined that the fair and just amount representing normal earnings to be used as petitioner's constructive average base period brandy net income, by reason of such change in character, was $ 20,779.74. Held, on the facts, that the fair and just amount representing normal earnings to be used as such constructive average base period brandy net income was not in excess of the amount determined and allowed by respondent.

Willard C. Mills, Esq., for the petitioner.

Royal E. Maiden, Esq., for the respondent.

Turner, Judge.

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TURNER

The respondent determined deficiencies and overassessments in the petitioner's income and excess profits taxes for the years and in the amounts as follows:

	Deficiencies		Overassessments
Year
	Income	Excess	Income	Excess
	tax	profits tax	tax	profits tax
Jan. 1-July 31, 1941	$ 513.43			$ 1,937.52
Ended July 31, 1942			$ 254.91	5,348.02
Ended July 31, 1943	4,431.29	$ 6,007.45
Ended July 31, 1944	3,716.93			542.42
Ended July 31, 1945	519.89	443.82
Ended July 31, 1946	147.70	486.80

The petitioner duly filed claims for relief under section 722 of the Internal Revenue Code for all of the years above. For the purposes here, there were two claims, one relating to the making and selling of wines, and the other, relating to the distilling and selling of brandy. With respect to the making and selling of wine, the petitioner's claims for relief were denied. With respect to the distilling and selling of brandy, the respondent determined that the petitioner qualified for relief under section 722 (b) (4) of the Code, but allowed only in part its claims as to what would have been "a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon comparison of normal earnings and earnings during the excess profits tax period." The questions for determination are (1) whether the petitioner, during the base period, changed the character of its wine business within the meaning of section 722 (b) (4) of the Code, and, if so, what is the fair and just amount representing normal earnings to be used as a constructive average base period net income for that purpose, and (2) whether, with respect to the claims for relief as they related to the brandy business, the amount determined and used by the respondent as the reconstructed average base period net income represented a fair and just amount to be used as "a constructive average base period net income" within the meaning of the statute.

General Findings of Fact.

A portion of the facts have been stipulated and, except as may hereafter appear, are found accordingly.

The petitioner is a Nevada corporation, organized in 1914, and has its principal office in St. Helena, California. Its income tax returns for the years in controversy were prepared on the accrual basis, and were filed with the collector of internal revenue at San Francisco. Prior to the taxable period January 1 through July 31, 1941, at which time the petitioner changed to a fiscal year ended July 31, the petitioner's returns were filed on a calendar year basis.

Facts Relating to the Wine Issue.

The petitioner is, and since its organization has been, a producer of fine wines, as was its predecessor, Beringer Brothers, a partnership, which began business at St. Helena, in 1876.

Wine is sold either as vintage wine or as blended wine. Vintage wine is the wine of a particular year's production. Blended wine is that produced by blending the productions of different years. The standard or quality of vintage wine is determined by the standard or quality of the grapes of the particular year from which it is made. Where the standard or quality of the grapes varies from year to year, the standard and quality of the wine also varies. The producers of blended wines seek to maintain a normal or uniform standard year after year for the wines sold.

"Fine" wines may mean blended wines or vintage wines. They may be produced from specific varieties of grapes or from several kinds of grapes of the same family. The petitioner has always sold blended wines and has never sold its wines as vintage wines.

Producers of fine wines, as distinguished from so called "commercial wineries," not only sell older wines, but their wine is aged in wooden containers, whereas commercial wineries use cement containers, which do not have the aging quality of wood. Commercial wineries indulge in a practice of freezing or pasteurizing young wines, in order to arrest or stop the continuing chemical reactions which would normally occur. Such wines do not have or approach the quality of fine wines, and are sold at much cheaper prices.

Most of the petitioner's storage is in underground cellars, and in relatively small casks or containers. Wine ages best next to wood and in the smaller casks the ratio of wood surface to the wine therein is greater than in the larger containers. The aging of wine, prior to sale, is a continuous process of movement, or racking as it is called in the industry, from one wooden cask to another. This is done by the use of pumps. No wine remains in a particular container for more than three months at a time. Wines of the same type and vintage year in small containers may be moved in the course of the racking process into a larger container. The segregation of the vintage as well as type is maintained, however, until the ultimate blending and bottling for sale. The racking or moving of the wine from one container to another also permits the removal of the sediment which has collected in the original container.

At all times material herein, the petitioner has produced and sold red and white dry wines and red and white sweet wines. Wines become dry through the fermentation of their sugar content into alcohol and unless fermentation is arrested all wine would become dry wine. The ratio of the alcoholic content so produced to the sugar content of the wine is one to two. To produce sweet wines brandy is added after the sugar content of the wine has been reduced by fermentation to the desired level. By this operation, the further fermentation of sugar into alcohol is arrested. The addition of the brandy also brings the alcoholic content of the wine up to the level at which the wine is sold. The alcoholic content of sweet wine usually ranges from 19.5 to 21 per cent. The alcoholic content of dry wine must be under 14 per cent and usually ranges from 12 to 13 per cent. Brandy is used in making dry wines only where the sugar content of the wine is not sufficient to produce the desired or required alcoholic content. The process of adding brandy to wine is termed fortifying the wine and the brandy so used is known as fortifying brandy, as distinguished from commercial or beverage brandy.

In addition to its winery, the petitioner also owned vineyards in which it raised varieties of red and white grapes. The grapes produced by it were best suitable for making dry wines. The vineyards did not produce enough grapes to supply petitioner's needs, however, and it purchased grapes from neighboring vineyards. The petitioner did not raise some types of grapes and some it "would be short of."

As its needs arose, the petitioner purchased wines from or traded wines with other wineries. Where the petitioner's inventory position was long in a particular type of wine, it would seek to trade some of that wine for a type of wine in which its inventory position was short. Farther south in California the grapes were not good for making dry wines and the production was largely in sweet wines. The petitioner at times needed more sweet wines and the wineries in the southern part of the state needed the types of wines made by petitioner. Trades were accordingly effected, usually on the basis of gallon-for-gallon. The petitioner would purchase wines only when it was unable to effect a trade.

During national prohibition, from January 17, 1920, to December 6, 1933, the petitioner's sales of wine were confined to the limited market for sacramental wines. A small number of other California wineries continued to operate during prohibition, producing sacramental, kosher, and medical wines. Most of the California wineries, however, ceased all wine production during prohibition.

With the repeal of prohibition, the demand for wine was greatly in excess of the productive capacity of the industry as it then existed. As a result, the wineries which had continued production during prohibition expanded their activities. Some wineries which had been closed during prohibition, reopened. Commercial wineries came into existence in great numbers and their number continued to increase during the years 1934 to 1937.

During prohibition only a few wholesalers or distributors were authorized to handle the wines used for the permitted purposes. Following repeal, wholesalers sprang up in great numbers and sought to acquire stocks of wine immediately. This initial stocking demand which followed repeal was largely filled by March or April of 1934, mostly with wines made from the 1933 grape crush.

Wineries which had operated during prohibition for the permitted purposes and had inventories of old wine at the time of repeal could have sold their entire stocks immediately. Some of the petitioner's competitors who had so operated sold their inventories at that time; the petitioner did not. A winery with a stock of old wines which it did not dispose of immediately after repeal, occupied thereafter a more advantageous position with respect to competitors who either had no old wines at the time of repeal or had sold their old wine inventories immediately. Competitors of the petitioner which came into existence after repeal did not have wines for sale of comparable age to petitioner's wines until 1937 or 1938.

In anticipation of repeal and of re-entering the fine wine business, the petitioner, as did other wine producers, began bottling wine shortly after July 1933. In 1933, it blended some of its sacramental wines with wines purchased from other wineries. It did not, however, terminate its sacramental wine business, but, to the contrary, has at all times since repeal continued in the business of making and selling sacramental wines.

During the years 1936 through 1939, the petitioner bottled and sold its wines under two brands or labels: Los Hermanos for its old wines and Mountain Ranch for its younger wines. ^{*620 wine was priced between that of old wines, such as Los Hermanos, and that of the cheap wines placed on the market by commercial wineries. Generally, it was the hope of petitioner eventually to cease or greatly reduce its sales of wine under the Mountain Ranch label and to sell all or substantially all of its wines under the Los Hermanos label.}

The California grape harvest or crush occurs from September to November of each year and that is the only period in the year in which grape wine is produced in that area. In the wine industry, wine that is produced from a current year's crush is classed as new wine, until the next year's production, when it is classed as old wine. In blending and bottling wine under the Los Hermanos label the petitioner, subject to an exception hereafter noted, has made it a practice of using wines which are two years of age, or older.

Large storage or aging capacity in relation to annual gallonage sales is essential in the production of fine wines. The petitioner's storage capacity after repeal was not adequate for its anticipated and planned operations. In 1935, it began an expansion of the storage capacity of its winery by 200,000 gallons. At September 1 of the years indicated, the storage capacity of the petitioner's winery was as follows:

Year	Gallons
1935	365,363
1936	507,899
1937	570,819
1938	573,270
1939	573,270

At December 31 of the years stated, the wine storage capacity of all California wineries was as follows:

Year	Gallons
1933	70,000,000
1934	95,000,000
1935	121,183,000
1936	139,592,000
1937	156,209,000
1938	165,002,000
1939	170,046,000

The petitioner's wine inventories as of January 1 of the years stated, were as follows:

Year	Gallons
1936	452,850
1937	464,539
1938	455,168
1939	478,989

By age, the January 1, 1936, inventory of 452,850 gallons consisted of the following: AgeGallonsInventory on hand September 1, 193385,3521933 production and purchases98,7051934 production and purchases38,2581935 production and purchases223,041Distilling materials6,694Total452,850

The total gross inventories of all wine in bonded wineries and bonded storerooms in California, other states and in the United States on December 31 of each year from 1933 to 1939, both inclusive, were as follows:

	California	Other states	Total U. S.
Year	inventories	inventories	inventories
	(gallons)	(gallons)	(gallons)
1933	34,763,000	Not available	Not available
1934	57,882,000	Not available	Not available
1935	91,824,000	Not available	Not available
1936	85,898,000	11,478,000	97,376,000
1937	114,079,000	15,629,000	129,708,000
1938	113,396,000	15,343,000	128,739,000
1939	116,040,000	18,632,000	134,672,000

The petitioner's wine production at St. Helena for the years 1936 through 1939 was as follows: *622

	Original production	Final production
Year	(gallons)	(gallons)
1936	149,277	129,571
1937	259,885	155,195
1938	223,404	159,570
1939	181,831	126,777

The petitioner's blends for bottling and selling wines are normally made in 20,000 gallon blending tanks. When withdrawals from a blending tank reduce the wine in the tank to the 10,000 gallon level, the petitioner's winemaster selects 10,000 gallons of appropriate wines from storage and thereby brings the blend in the tank back to the 20,000 gallon level. During 1936 through 1939, the petitioner's inventories of aged wines were not such as to permit the blending of large quantities of wine at one time. The batches blended being smaller, more frequent blendings were required. One result was that a greater part of the petitioner's storage capacity had to be left open than would have been the case if the blending could have been done in larger batches. The storage capacity thus left open was approximately ten to twenty per cent of total.

The petitioner's wine sales, with the exception of those made at its retail store on its premises at St. Helena, were made through Beringer Brothers Sales Agency, a sole proprietorship owned by Charles Beringer, who has been president of the petitioner since about 1918. In February 1936, the sales agency hired a new manager, a native of France, who had come to the United States in 1927. He was an experienced and aggressive wine salesman, and thought that the position as sales manager for the petitioner's products offered a good business opportunity. He knew that the petitioner's prestige was high and it was his belief that the petitioner's winery was one of the finest in the United States. Fred Abruzzini, petitioner's winemaster, and manager of its winery and vineyards, was determined, in so far as he was able, to maintain the high quality of the petitioner's wines. He was of the opinion that the petitioner did not have enough aged wine "to stay in the Los Hermanos business straight through with the capital we had to work with." The sales manager proposed that efforts be made to promote increased sales of the Mountain Ranch brand, which, though a cheaper and younger wine, was in his opinion "a very fine wine at 25 per cent or 30 per cent higher than the Roma commercial wines at that time." For the years 1936 and 1937 the sales of Mountain Ranch wine were increased over the sales of "new wines" in prior years at a substantially greater rate than were the sales of Los Hermanos wines over prior sales of "old wines." During this time, Abruzzini was complaining to Beringer that his inventory of good wines was being depleted and that sales should be cut until the inventory could be built up again. By 1938, the petitioner's stock of aged wine had been so reduced that it became necessary to curtail sales, to some extent, if the established standard for petitioner's wines was to be maintained. Abruzzini convinced Beringer that such was the case and Beringer, in turn, advised his sales manager of the situation. Petitioner's sales of wine under the Mountain Ranch label were less in 1938 and 1939 by approximately one-third of the total sales of that brand of wine in 1937. In an attempt to maintain an adequate supply of wine under the Los Hermanos brand, the petitioner, in 1938, blended 100,000 gallons of its new wine produced in 1937 directly into approximately 32,000 gallons of its aged wine inventory. The sales of wine under the Los Hermanos brand in 1938 and 1939 were approximately at the level of such sales for 1936 and 1937 respectively, but difficulties were encountered with respect to some of the lot which contained wine from 1937 production. In one instance, the sales manager, on a subsequent trip to Philadelphia, found that one of his distributors who had bought two carloads of the wine in question had found the wine unsuitable for his trade and was disposing of it through other channels.

The petitioner's wine sales in gallons for the years 1934 to 1940, inclusive, were as follows:

				Bulk sales to
Year	Total	Old wine New wine 1	other
				wineries
1934	89,275	67,526	14,973	6,776
1935	149,530	72,856	44,504	32,170
1936	171,214	92,773	69,162	9,279
1937	203,625	86,696	78,589	38,340
1938	149,677	93,519	53,753	2,405
1939	141,835	86,303	51,272	4,260
1940	181,747	100,123	74,311	7,313

The total "apparent" consumption of California wine in California and in all markets for the years 1936 through 1939, as shown in Wine Institute Bulletin No. 186, was as follows:

Year	In California	In all markets
	(gallons)	(gallons)
1936	19,958,569.78	53,934,364.12
1937	19,470,892.77	58,046,952.91
1938	19,147,706.71	55,000,969.73
1939	18,421,394.87	64,582,601.62

The total "apparent" consumption of wine in the United States, according to origin, for the years 1934 through 1939, as shown in Wine Institute Bulletin No. 186, was as follows:

	California		Wine from
Year	wine	Per cent	other states	Per cent
	(gallons)	of total	(gallons)	of total
1934	26,166,000	79.97	2,706,000	8.27
1935	40,049,000	87.50	2,961,000	6.47
1936	53,912,000	89.27	2,854,000	4.72
1937	57,988,000	86.78	5,031,000	7.53
1938	54,944,000	81.85	8,789,000	13.09
1939	64,505,000	84.05	8,323,000	10.85

	Foreign	Per cent	Total
Year	wine	of total	all wine
	(gallons)		(gallons)
1934	3,849,000	11.76	32,721,000
1935	2,759,000	6.03	45,769,000
1936	3,627,000	6.01	60,393,000
1937	3,800,000	5.69	66,819,000
1938	3,399,000	5.06	67,132,000
1939	3,914,000	5.10	76,742,000

For 1934 through 1939, and exclusive of bulk sales to other wineries, the percentage of the petitioner's wine sales of the total "apparent" consumption of wine in the United States was as follows:

			Petitioner's sales
	Petitioner's	United States	as percentage of
Year	regular wine	wine consumption	United States
	sales in gallons	in gallons	consumption
1934	82,499	32,721,000	.002521
1935	117,360	45,769,000	.002564
1936	161,935	60,393,000	.002681
1937	165,285	66,819,000	.002473
1938	147,272	67,132,000	.002193
1939	137,575	76,742,000	.001792

In addition to the expansion of its wine storage facilities, which began in 1935, the petitioner also in 1935 erected a distillery for making brandy. The construction of the distillery and the building of additional wine storage facilities were financed, to some substantial extent, by Federal loans. Even with the new construction petitioner's wine storage was "not enough for what" it "was striving for." It had gone as far with new construction, however, as building space at its winery and its financial condition would permit, "and it was cheaper to go and find another method of getting the inventory."

In 1936, Abruzzini, while looking for some wine to make fortifying brandy, visited the winery of J. C. Fawver which was located about twelve miles from the petitioner's property. Petitioner from time to time was also looking for some older wines. Fawver also owned about 400 acres of vineyard. The storage capacity of his winery was approximately 573,000 gallons and normally his annual wine production was about 200,000 to 225,000 gallons. Fawver, an elderly man, was acting as his own winemaster and was having trouble with his wine making. His winery had been closed during prohibition and his tanks had become contaminated.

Abruzzini found that much of Fawver's wines were too high with acid for beverage purposes. In talking with Fawver, Abruzzini explained that the best thing to do would be "to make some commercial brandy of those wines, and then clean up the cellar and make good wines for aging." Petitioner bought some of the wine and made it into brandy. The remainder, as will be set out in greater detail in the findings under the brandy issue, it made into brandy for Fawver's account. At Fawver's request, Abruzzini advised and assisted him in the cleaning up of his winery.

In the latter part of 1936, the petitioner and Fawver entered into an oral agreement, under which Abruzzini was to supervise the making and aging of Fawver's wines, commencing with the 1937 grape crush, and in return therefor the petitioner was to have the first right to buy, or refuse to buy, the wines so produced by Fawver under Abruzzini's supervision at the market price or at the highest price above market offered to Fawver by anyone else. Under that agreement, Abruzzini supervised the production and aging of Fawver's wines for 1937, 1938, and 1939, the actual work being done by Fawver's employees. It was understood that the petitioner would buy sufficient of Fawver's wines, or in the absence of such purchase that Fawver would have the right to sell enough of his wine, to allow sufficient space in his winery to store the wine production from his grape crop each year.

On December 7, 1939, after the production for 1939 had been completed, and just prior to Fawver's admission to a hospital for an operation, the oral agreement was superseded by an agreement in writing. Under the written agreement, petitioner was to use its best efforts to distribute all of the red wine made at the Fawver winery. The plan was that petitioner was to buy only 3-year-old red wine, the wine to be bought in the first year to be wine of the vintage year 1937. Of the 1937 wine, it was to buy 20,000 gallons within 30 days at 17 cents per gallon, f. o. b. Fawver's winery. It was given an option to buy up to 125,000 additional gallons, in lots of not less than 20,000 gallons, within 6 months at the same price and under the same conditions, and an additional 125,000 gallons during the second 6 months. It was contemplated that the option, if exercised, would absorb Fawver's entire annual vintage of red wine and Fawver agreed not to sell any such wine to any third party until Beringer's option to buy should expire. At Beringer's option the agreement was subject to renewal one year from date and at the end of each 6 months thereafter for a total period of 3 years, each renewal to be at a price determined by mutual agreement.

The wines produced at the Fawver winery, although available to the petitioner whenever needed, remained the property of Fawver until actually purchased by petitioner. Prior to the written agreement, there being no specified period within which petitioner was required to purchase the wine, the petitioner purchased wine from Fawver only as it was needed for blending and bottling. Wine purchased after the execution of the written agreement which was not needed immediately remained at the Fawver winery for aging. The wines purchased from Fawver, as in the case of wines obtained by petitioner from other sources, were taken by the petitioner to its winery for blending with its own wines.

At the time the petitioner entered into the oral agreement with Fawver in 1936, it was the petitioner's intention to exercise the right to purchase which it acquired under the agreement. The petitioner eventually did purchase all of the wines produced by Fawver from the grape crops of 1937, 1938, and 1939, though most, if not all, of it was purchased after 1939, with purchases after that year being as follows:

	Gallons purchased
Wine produced in
	1940	1941	Total
1937	41,092	151,792	192,884
1938	127,201	21,459	148,660
1939	108,053	47,856	155,909

The California commercial grape crush tonnage for the vintage years 1933 through 1939 and the prices paid per ton by the petitioner for wine grapes purchased from outside sources during 1934 through 1939, were as follows:

		Prices per
Year	Tons	ton paid by
		petitioner
1933	444,000
1934	530,000	$ 18.04
1935	887,000	13.70
1936	493,196	21.15
1937	911,239	22.38
1938	862,090	15.44
1939	711,528	14.75

In the spring and early summer of 1938, it became apparent to the informed grape growers and vintners of California that a serious economic problem for both elements of the grape industry impended. The 1935 and 1937 crops had been heavy. There was a large carryover of wine, both dry and sweet, from former years. Because of an overproduction in grapes in 1938, a wine grape prorate committee organized, effective as of September 1, 1938, the Growers Grape Products Association, for the purpose of arranging for the receipt and processing of the surplus grapes by the association. About 10,000 grape growers and some 250 wineries in California participated in the program. The association diverted 45 per cent of the wine grape crop of 1938 into the production of beverage brandy and high proof brandy, thereby keeping this tonnage out of competition with regular wine production. The immediate effect was to reduce the 1938 potential wine production by 37,500,000 gallons. Because of the extent to which they were already filled, the storage facilities of the California wineries, including the petitioner's, would have been unable to hold all the wine that could have been made from the 1938 grape crop. Approximately four gallons of wine are required to produce one gallon of brandy. After it was made, the brandy went into Government warehouses, and not into the wineries.

If the petitioner had had an adequate stock of aged wines, its wine sales would have been greater in 1938 and 1939 than they were in those years.

Facts Relating to Brandy Business.

From the repeal of prohibition in 1933 up to 1935, the petitioner made no brandy. Prior to prohibition, it had made a very fine cognac brandy, using for that purpose a small pot still. The pot still was not used after repeal because the operation would have been too costly. Approximately four gallons of wine is required to make one gallon of brandy and the pot still would take only about 450 gallons of wine at one operation.

In 1935, the petitioner, as heretofore found, erected a distillery. This distillery had a capacity of 6,644 proof gallons of brandy in 24 hours. Commencing with the erection of the distillery, the petitioner began distilling its own fortifying brandy for use in the making of its sweet wines. It did not begin making commercial or beverage brandy, however, until 1937. For making fortifying brandy the petitioner, as previously found, used grape wash and higher acid wines. Good wines are required for making good beverage brandy, although poorer wines can be utilized in making brandy that will sell, than can be used in making fine or quality wines. "The better the wine," however, "the better the brandy." In entering the commercial brandy field, the petitioner intended to manufacture and sell a high quality brandy, in keeping with the standard of its wines.

At some time after Abruzzini's visit to the Fawver winery in 1936 and as early as March of 1937, the petitioner decided to purchase a quantity of the acid wine which Fawver then had on hand and make it into commercial brandy. It purchased enough of the wine to make 33,895 original proof gallons of brandy and in March or April of 1937, the wine was distilled into brandy. The price of the wine was 12 cents per gallon. It did not pay for the wine immediately, but, after storing the brandy in a bonded warehouse, turned the warehouse receipts over to Fawver as security for the amount due. The understanding was that as petitioner desired to withdraw the brandy from the warehouse for sale, it could obtain release of the warehouse receipts by making a payment on the amount owing for the wine. At the time of distilling the brandy, the petitioner was actually out of pocket the amount of its expenses in distilling and placing the brandy in storage and $ 6.50 for each barrel used.

The remainder of the wine at the Fawver winery at the time of Abruzzini's visit in 1936 was distilled into brandy during the years 1937, 1938, and 1939, for Fawver's account. The wine so distilled into brandy for Fawver's account and by petitioner for its own account was of high acid content and was not suitable for beverage wine purposes. A volume of "first class wine, the type" petitioner would have liked to use to start its brandy business could not be found in 1937. The Fawver wine was the best wine it could find "that was available."

For the brandy processed for Fawver, the petitioner was paid a fee. It also had an oral understanding that it should have a right to purchase the brandy so made and in August of 1939, it purchased from Fawver the brandy, 12,683 gallons, it had made for him in 1937. Petitioner did not, however, make any payment to Fawver therefore at the time of the purchase nor at any time during the base period. Under date of August 1, 1939, Fawver, in two separate written instruments, gave the petitioner the right and privilege of purchasing the brandy petitioner had made for his account in 1938. Under the first writing, the petitioner had the option of buying 16,993.13 proof gallons, original gauge, of brandy distilled during the months of June and July, 1938, at 80 cents per proof gallon, original gauge, plus any sum paid by Fawver for taxes, storage or warehousing and insurance. The option was to expire on the first day of August 1940. Under the other writing, Fawver gave the petitioner the right and privilege of purchasing 13,546.47 proof gallons, original gauge, of brandy distilled by petitioner for him during the month of July 1938. For such brandy, the petitioner was to pay the same price and costs as under the option above. The second option was to expire on August 1, 1941. *187 Without Fawver, the petitioner did not have enough wine for the wine business, "let alone going into the brandy business at that time." Its financial condition was also a limiting factor.

As a part of its program to divert a substantial portion of the California 1938 grape crop from wine into brandy and "high-proof," the Growers Grape Products Association in September of 1938 entered into an agreement with the petitioner to process into brandy and "high-proof" the wine grapes delivered by the association to petitioner under the terms of the agreement. The association was an emergency organization, formed to deal with the problem of the California vineyards and wineries resulting from the overproduction of grapes in 1938, and it operated only with respect to the crop for that year. Pursuant to the contract, the petitioner at its distillery processed wine into brandy for the association both in 1938 and 1939. For this work, it was paid a processing fee by the association. The association furnished the barrels for the brandy and the costs of transporting the brandy from the petitioner's plant to the warehouse. It was provided, however, that the petitioner, subject to certain terms and conditions, should have the right to buy the brandy so processed by it for the association. In that connection, the contract contained the following provision:

The processor understands that the association is financing the operation of receiving, processing, coopering, aging, sale and distribution of the said brandy and high-proof through credit obtained or to be obtained from certain banks and/or governmental and/or other lending agencies, and that under the terms of the loan or hypothecation agreements to be entered into by the association with such lending agencies, the association may be required from time to time to sell the whole or any portion of the brandy or high-proof so hypothecated. Subject to the foregoing limitations, the association agrees that, unless required by such lending institutions so to do, the association shall not sell any commercial brandy processed by the processor for the association prior to September 1, 1940, to any person other than the processor. The association shall not either before or after September 1, 1940, sell at any price any quantity of commercial brandy processed for the association by the processor to any person, unless the association shall have first offered to sell the same to the processor at the same price and upon the same conditions, and unless the processor shall have failed or refused to accept said offer in writing or by telegraphic notification delivered within five (5) days from the date of the making of such offer. Nothing herein contained shall be construed in any manner to limit or restrict the absolute and unconditional right of such lending institutions to sell all or any portion of the commercial brandy processed by the processor at any price should the association fail to sell such commercial brandy at prices or in a manner satisfactory to such lending institutions.

The commercial or beverage brandy produced by the petitioner for its own account, for Fawver and for the Growers Grape Products Association during 1937 through 1939, was as follows:

	Original proof gallons
	1937	1938	1939
For own account	33,895		6,947
For Fawver's account	12,683	30,540	9,782
For Growers Grape Products Association		87,912	24,428
Totals	46,578	118,452	41,157

A gallon of straight alcohol at 60 degrees Fahrenheit is said to be 200 proof or two proof gallons. A gallon liquid measure which is 100 proof is one-half alcohol and one-half something else. According to Government regulations, fortifying brandy is made at 160 proof to 190 proof. Commercial or beverage brandy is made at 170 proof, and below. The petitioner normally brings its fortifying brandy up to 180 to 185 proof. Its commercial brandy it makes at 140 to 160 proof. After the brandy is distilled, it is placed in barrels for storage in bonded warehouses at 103 proof. The reduction in proof is brought about by the addition of distilled water under Government supervision. The proof at which the brandy is placed in bonded storage is referred to as original proof. The tax is paid on the basis of proof at the time of withdrawal. Due to evaporation which occurs during storage, regauging at the time of withdrawal is necessary. After withdrawal and payment of the tax, the petitioner bottles its brandy for sale at 90 proof. If, for instance, the brandy is 104 proof when regauged, water is added to bring it down to 90 proof.

The book costs to the petitioner for producing beverage brandy for its own account during the base period were as follows:

	1937	1939
Gallons produced (original proof gallon)	33,895	6,947
Cost of production	$ 22,449.55	$ 4,125.69
Cost per original proof gallon	$ 0.6623	$ 0.5930

Of the brandy made by the petitioner in 1937 for its own account from wine purchased from Fawver, it sold in that year 10,457 original proof gallons in bulk in one sale. The brandy sold was out of the first batch of brandy made. By this sale, petitioner was making a profit and was also getting rid of some brandy made out of the higher acid wine than brandy "it would like to age." Bulk sales of brandy were not unusual in the industry. Such sales were usually by one operator to another and the margin of profit was small when compared to bottled brandy sales.

In 1939, the petitioner withdrew from bulk inventory 2,745.18 original proof gallons of brandy which it had made for its own account in 1937, from which it bottled 2,680 gallons liquid measure of 90 proof brandy. Of the brandy so bottled, it sold in 1939, 2,196 gallons. Gallons, liquidAmountmeasurereceivedSales at wholesale1,370.31$ 7,168.04Sales at retail825.685,072.93Total2,195.99$ 12,240.97

The brandy made by the petitioner for its own account in 1937 and for Fawver's account, having been made from wines of a high acid content, was not brandy of the quality which petitioner desired to age and establish on the market. The brandy bottled and sold in 1939 was not as "high acid" as the 10,457 gallons sold in bulk in 1937. It "was fair, but not of the best." It was the best the petitioner had, however, and its sale was prompted by petitioner's desire to get its label on the market as quickly as possible. *193 The brandy sold in 1939 was 2-year-old brandy and, as in the case of wine, the bottled brandy sales, except those made through the retail store on its premises, were made through Beringer Brothers Sales Agency. The petitioner sold in 1939 all of the bottled brandy it could sell. In that year its only 2-year-old brandy was that made from Fawver wines in 1937. It was not until the fall of 1938, when it made brandy under the prorate plan and acquired rights of purchase thereto, that brandy of the quality desired by petitioner for its brandy business became available. The prorate brandy was "made from new wines that were made from good grapes and low acids." This brandy would not be 2 years old until the fall of 1940, or 4 years old until the fall of 1942.

In a liquor store, brandy is not one of the faster selling items and after the shelves are stocked it is difficult to introduce a new line or brand. When petitioner began its sale of 2-year-old bottled brandy in 1939, it was at a competitive disadvantage. The demand was for 4-year-old brandy, and its competitors had 4-year-old brandy. Those who had started operations immediately after repeal had 4-year-old brandy in late 1937, or shortly thereafter. The main factor in launching the sale of the petitioner's brandy was the prestige of the name Beringer Brothers. The effect was limited, however, to those who had known Beringer products before prohibition. If petitioner had begun making commercial or beverage brandy in 1935, instead of 1937, it would have had 2-year-old brandy for sale in 1937 and 1938 and it could have sold in each of those years approximately the same amount it actually sold in 1939, and its sales in 1939 of less than 4-year-old brandy would not have been much greater than they actually were in that year. It could have anticipated only a normal increase through trade acceptance of its label.

The following is a statement in proof gallons Fiscal year (ending June 30)CaliforniaOther StatesUnited States19342,324,0001,390,0003,714,00019351,300,000543,0001,843,00019361,688,000800,0002,488,00019371,439,000490,0001,929,00019382,518,0001,106,0003,624,0001939400,0009,183,000

The following is a statement in proof gallons CalendarProducedPer centProducedPer centTotalyearin Californiaof totalin otherof totalUnitedStatesStates19351,191,00058.58397,00019.531,588,00019361,332,00055.04443,00018.311,775,00019371,447,00054.24483,00018.101,930,00019381,085,00048.20501,00022.261,586,00019391,223,00050.98407,00016.971,630,000

Calendar	Per cent	Foreign	Per cent	Total
year	of total		of total
1935	78.11	445,000	21.89	2,033,000
1936	73.35	645,000	26.65	2,420,000
1937	72.34	738,000	27.66	2,668,000
1938	70.46	665,000	29.54	2,251,000
1939	67.95	769,000	32.05	2,399,000

The following is a statement in proof gallons On December 31Beverage19352,234,00019362,635,00019373,687,000193813,163,000193912,488,000

Miscellaneous and Ultimate Facts Relating to One or Both Issues.

According to the petitioner's books, its profits on wine and beverage brandy, its miscellaneous or "other" income, all before any charge for general administrative expenses and expenses of financing, its general administrative expenses and expenses of financing, and its total net profits, after allowing for such expenses, for the years 1936 through 1939, were as follows:

		Beverage
Year	Wine	brandy	Other
1936	$ 49,579.17		$ (1,475.45)
1937	47,578.51	$ 400.62	1,826.67
1938	41,870.59	(650.91)	10,933.64
1939	41,950.62	2,474.36	1,270.12
Total	$ 180,978.89	$ 2,224.07	$ 12,554.98
Average	$ 45,244.72	$ 556.02	$ 3,138.75

	General administrative
	and	Total net
Year	and financing
	expenses
1936	$ 26,951.79	$ 21,151.93
1937	31,550.09	18,255.71
1938	33,045.71	19,107.61
1939	33,750.66	11,944.44
Total	$ 125,298.25	$ 70,459.69
Average	$ 31,324.56	$ 17,614.92

The petitioner's excess profits net income for each of the base period years, computed under section 713 of the Internal Revenue Code, for the purpose of determining its excess profits credit under the income method for each of the excess profits tax years involved herein, is as follows:

1936	$ 21,151.93
1937	18,255.71
1938	1939	11,944.44

The 4-year average resulted in an actual average base period net income of $ 17,764.92, which produced an excess profits credit under the income metohd of $ 16,876.67 (95 per cent of $ 17,764.92).

The excess profits credits taken by the petitioner on its returns in computing its excess profits tax liabilities were computed by the use of the invested capital method, under section 714 of the Code, which produced a larger credit than resulted from the use of the income method under section 713. The excess profits tax credits taken and allowed were as follows:

Year	Amount
Jan. 1 through July 31, 1941	$ 25,140.81
Year ended July 31, 1942	28,901.70
Year ended July 31, 1943	30,617.65
Year ended July 31, 1944	30,314.62
Year ended July 31, 1945	37,475.94
Year ended July 31, 1946	37,839.32

With respect to all years herein, the petitioner filed claims for relief under section 722 (b) (4) and (5) of the Code. As to wine, its claim was that, by reason of its arrangement with Fawver, beginning in 1937, there was a change in the character of its business within the meaning of section 722 (b) (4) and that its wine business did not, by the end of the base period, reach the earning level which it would have reached if the taxpayer had made the change 2 years before it did. With respect to its brandy business, it likewise claimed that it changed the character of its business in 1937, within the meaning of section 722 (b) (4), and that its brandy business did not reach the earning level which it would have reached if it had made the change 2 years before. The change claimed with respect to the wine was that the arrangement with Fawver effected an increase in its capacity for production or operation. In the case of the brandy, two changes were claimed: One, that in 1937 beverage brandy, a new product, was introduced, and two, that the arrangement whereby it had the privilege of buying the beverage brandy which it made for Fawver's account also effected a change in its capacity for production or operation of its brandy business. The petitioner likewise claimed that it was entitled to relief under section 722 (b) (4), in that these changes in its capacity for production or operation, to which it was committed prior to January 1, 1940, were not consummated until after December 31, 1939. Its claim for relief under section 722 (b) (5) was based on the same general facts as were advanced for its claims under section 722 (b) (4).

The respondent allowed one claim only and denied all others. The claim allowed was that the petitioner in 1937 did change the character of its business, in that it began the production and sale of commercial or beverage brandy, a new product, and that by reason thereof, petitioner was entitled to reconstruct its base period net income on the basis of having made the change 2 years before it did. Based on this allowance, the respondent determined that if the petitioner had commenced the production of beverage brandy in 1935, instead of 1937, it would have sold an average of 33,368.81 gallons for the base period years and that its average base period net income from commercial or beverage brandy would have been $ 20,779.74. Of that amount, $ 577.10 represented average base period brandy net income determined as having been actually realized, which made $ 20,202.64 as the amount which was added to the $ 17,764.92, petitioner's actual average base period net income, to arrive at $ 37,967.56, the amount determined and allowed by respondent as petitioner's constructive average base period net income.

If the petitioner had commenced producing and selling commercial or beverage brandy in 1935, instead of 1937, its average base period net income therefrom would not have been in excess of $ 20,779.74.

If the petitioner had started operations under the Fawver agreement in 1935, instead of 1937, its average base period net income from its wine business would have been $ 2,000 greater than it actually was.

OPINION.

The petitioner does not question the correctness of the respondent's determination of its excess profits tax, computed without the benefit of section 722 of the Internal Revenue Code. It does contend, however, that the tax so computed is excessive and discriminatory if section 722 (b) (4) of the Code *202 The petitioner has alleged error by the respondent as to both wine and brandy. Under the wine issue, there are two questions for determination, namely, whether the beginning of operations under the Fawver agreement in 1937 was a change in the character of petitioner's business within the meaning of section 722 (b) (4), and, if so, what is the amount at which its average base period net income is to be reconstructed by reason thereof. Under the brandy issue, we have only the problem of determining the amount at which the average base period net income is to be reconstructed, since the respondent has already determined, and here concedes, that a change in the character of the brandy business did occur in 1937, when petitioner began the production of commercial or beverage brandy, a new product.

The petitioner has raised no issue under section 722 (b) (5), and at the hearing, its counsel specifically disavowed any claim that there was, by reason of the commencement of operations under the Fawver agreement or of the beginning of the production of commercial brandy in 1937, any change in its "capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer [petitioner] was committed prior to January 1, 1940."

The petitioner makes no claim that its wine sales would have been any greater in 1936 and 1937 if it had begun operations under the Fawver arrangement in 1935, instead of 1937, but is does claim that such sales would have been substantially greater in 1938 and 1939 than they actually were. In substantiation of this claim, it points to the drop in 1938 and 1939 in the volume of wine sold and argues that this drop was brought about by the depletion of its wine inventories through the increased sales in 1936 and 1937 and its lack in those years of adequate facilities for storing and aging enough wine to maintain the said inventories at a proper level, all of which would have been avoided if operations under the Fawver agreement had commenced two years before they did.

It is the claim of the respondent, on the other hand, that there being no actual expansion or change in the petitioner's physical plant, and since the petitioner did not, under the arrangement, produce and store wine for its own account but for Fawver and if and when it desired to acquire the Fawver wine for blending and bottling with its own wines for sale, it was required to pay the current market price therefor or to meet the best offer Fawver might receive from an outside party, the petitioner was, for all practical purposes, in no different position with respect to the Fawver wines than it would have been with respect to any other wines which might be bought in bulk in the open market and that an arrangement for such buying of wine if and when needed does not qualify as a change in petitioner's capacity for production or operation within the meaning of the statute.

The petitioner's standing in the trade as a producer of fine wines had been established long since. It did not sell its wines as vintage wines but as blended wines, seeking to maintain the high standard of quality for its products year after year. During prohibition, it had been authorized to produce and sell wine for sacramental purposes, and at repeal had an inventory of old wine on hand. With repeal, the demand for wine was greatly in excess of the productive capacity of the industry as it then existed, and those producers having wine inventories could have sold their entire stocks of wine immediately. Some of the petitioner's competitors did sell their stocks, but petitioner did not. It desired to maintain its standing as a producer of fine wines and an adequate stock of aged wine for blending was essential if that purpose was to be carried out.

By the end of 1936, wine consumption in the United States had doubled what it had been in 1934, and from 1936 to 1939, continued to increase steadily, although at a slower rate. Petitioner's problem was to keep its sales in step with the growth of the wine industry generally and at the same time to build up its inventory of aged wine to the desired and needed level. Toward that end it began, in 1935, the construction of additional storage facilities and by September 1, 1937, had increased its capacity for storing and aging wine from 365,363 gallons to 570,819 gallons.

The petitioner sold both old wine and new wine. At some point of time, as early at least as 1936, it began selling its old wine under the label Los Hermanos and its new wine under the label Mountain Ranch. In blending and bottling its Los Hermanos or old wines, petitioner has made it a practice of using wines which have been aged for two years, or more. In 1934 the ratio of its old wine sales to sales of new wine was approximately four and one-half to one, but in 1935 the sales of new wine increased at such a rate that the ratio had dropped to slightly less than two to one. Early in 1936, at the instigation of a new sales manager, a program of further promoting the sales of new or Mountain Ranch wine was instituted. In that year the ratio of old wine sales to sales of new wine became approximately four to three, and in 1937 it was in the neighborhood of ten to nine.

It had already become apparent to the petitioner's manager and winemaster that it could not, with its existing wine inventories and the space which it had for storing and aging wine, continue wine sales at the 1936 and 1937 rates if the established standard and quality of its wines was to be maintained. It could continue the current rate of promotion and sale of its new or Mountain Ranch wines only at the expense of Los Hermanos. Otherwise it would have to cut back its wine sales so as to store and age a sufficient quantity of its new production each year to provide the needed amounts of aged wines for blending and sale under the Los Hermanos label, or it would have to find some other means of supplying itself with such wines. It was faced with these alternatives because it was not in a position to increase further its own plant. In addition to the construction of the added wine storage facilities beginning in 1935, it had in that year also erected a distillery for making brandy. As a result, it had gone as far with new construction as its finances would permit. It had also utilized substantially all of the building space which it had available.

In the arrangement with Fawver, the petitioner found a solution to its problem, but not in time to prevent a cutback or drop in its sales for 1938 and 1939. Operations under the Fawver arrangement did not begin until 1937 and wines from the 1937 grape crush would not be ready, under petitioner's usual practice, for blending and sale as Los Hermanos wines until 1939, and later. Furthermore, in an attempt to maintain an adequate supply of wine for sale under the Los Hermanos label, the petitioner in 1938 made a departure from its usual practice and blended 100,000 gallons of its 1937 wine production with approximately 32,000 gallons of its aged wine. *208 label in 1938 and 1939 were approximately at the level of such sales for 1936 and 1937, respectively, whereas sales under the Mountain Ranch label were substantially reduced. The ratio of Los Hermanos sales to Mountain Ranch sales in both 1938 and 1939 was about five to three, as compared with ratios of four to three in 1936 and ten to nine in 1937.

It is true, as the respondent contends, that the petitioner did not, under the Fawver arrangement, expand or change its own physical plant or increase its owned wine inventories to any substantial extent during the base period, and undoubtedly, the picture case, so to speak, representing a change in capacity for production or operation, under the statute, would be a case where there was a change in the taxpayer's physical capacity for production or operation. Even so, however, we think the position of the petitioner is well taken and that it did, through the Fawver arrangement, effect a change in its capacity for production or operation within the meaning of the statute. At the time the agreement was made Fawver's storage tanks were contaminated with acid and the wine stored therein was not, to say the least, a desirable wine for sale as beverage wine. Under the arrangement, the petitioner furnished the services and advice of its winemaster in cleaning up the Fawver winery and putting it in proper condition for the storing and aging of fine wines. Also Fawver was to receive and did receive the supervisory services of petitioner's winemaster in the making of his wines, beginning with the 1937 grape crush, and in the subsequent operations connected with the storing and aging of that wine. In return, Fawver agreed that petitioner should have the right to acquire his entire wine inventory made under the agreement. If it became necessary or desirable for him to sell, he agreed first to give the petitioner the opportunity to buy the wine to be sold, at the current market price or at the highest price offered by any outside party. There is every indication, from the record made, that both Fawver and the petitioner looked upon the agreement as one under which petitioner would acquire all of his wines. There is no doubt, we think, that petitioner from 1937 on included the Fawver wines in its plans for future operations, just as it did its own production. Petitioner's financial condition at the time made the arrangement particularly attractive. Unless for some reason Fawver found it necessary or desirable to sell some of the wines at an earlier date, petitioner was not required to expend anything but a portion of its winemaster's time, until the wines were needed for blending and bottling for sale. Fawver's winery was within twelve miles of petitioner's winery and petitioner's manager and winemaster could supervise Fawver's operations in substantially the same manner as he did those of the petitioner. The situation being as described, it is our opinion that the petitioner did in fact increase its capacity for producing, storing and aging wine by reason of the agreement with Fawver.

In corroboration, it appears that the workout under the arrangement was for all practical purposes as effective as if petitioner had acquired in its own right the facilities used. The petitioner, in due course, did acquire all of the wine produced, stored and aged for Fawver under the supervision of its manager and winemaster. In December 1939, when Fawver was entering a hospital for an operation, the oral agreement was changed into a written agreement. This agreement contemplated that petitioner would buy Fawver's 1937 vintage red wine in the first year, the 1938 wine the second year and the 1939 wine the third year. The terms were that it was to buy 20,000 gallons of the 1937 vintage in thirty days, at 17 cents per gallon, and was to have options to buy 125,000 additional gallons the first 6 months and 125,000 gallons more the second 6 months, all at the same price. At petitioner's option, it could renew the agreement one year from date and at the end of each 6 months thereafter, for a total period of 3 years, so as to buy Fawver's 1938 and 1939 red wine at prices to be agreed upon. It was contemplated that the options, if exercised, would absorb Fawver's entire annual vintage of red wine and Fawver agreed not to sell any such wine to any third party unless petitioner's options to buy should expire. The first of the wines made for Fawver under Abruzzini's supervision were two years old in September or October of 1939, and in 1940 petitioner's sales of Los Hermanos wines were 100,123 gallons, as compared with 93,519 gallons for 1938, the highest for any prior year, and with 86,303 gallons for 1939, and its Mountain Ranch sales were 74,311 gallons, as compared with 51,272 gallons for 1939, 53,753 gallons for 1938, and 78,589 gallons for 1937.

By and under the Fawver agreement, which became effective with the grape crush of 1937, the petitioner did effect a change in its capacity for production or operation of its business within the meaning of section 722 (b) (4), and its wine business did not, by the end of 1939, reach the earning level which it would have reached if petitioner had commenced operations under the agreement in 1935, instead of 1937.

As against respondent's determination of a constructive average base period net income of $ 37,967.56, the petitioner contends that $ 62,614 is the fair and just amount to be used as its constructive average base period net income, an increase of $ 24,646.44. It has made no attempt, however, to show what part of the claimed increase of $ 24,646.44 would be attributable to wine and what part to brandy. Its accountants have indulged in some very elaborate and complicated tabulations in which their conception of the claimed results of the wine, brandy and miscellaneous operations have been segregated, except for what are termed general administrative and financing expenses. These latter expenses have not been allocated between the three categories mentioned, but have been deducted in a lump sum from the aggregate of the wine, brandy, and other profits, computed as stated, to arrive at the claimed constructive average base period net income of $ 62,614. The respondent, on brief, has attempted an analysis of the said tabulations up to the point of demonstrating that of the claimed increase of $ 24,646.44 in constructive average base period net income, only $ 3,741 is claimed as the average base period net profits which would have resulted from the added wine sales claimed for 1938 and 1939. The petitioner, in its reply brief, does not challenge the correctness of the respondent's figure of $ 3,741, and we accordingly conclude that it accepts that figure as being a proper statement of its claimed added average base period net income attributable to wine. In such circumstances, it would follow that the remainder of the $ 24,646.44, or $ 20,905.44, is the amount petitioner claims as the average base period net income that would have resulted from brandy sales over and above the increase with respect thereto already allowed by the respondent in his determination, and if a breakdown of the total claimed average base period net income of $ 62,614 be approached in that manner, the result would appear as follows:

Constructive average base period net profits from brandy allowed
by respondent	$ 20,779.74
Actual average base period net income from wine and miscellaneous
operations as determined by respondent	17,187.82
Total	37,967.56
Additional constructive average base period wine net income
claimed by petitioner	3,741.00
Additional constructive average base period brandy net income
claimed by petitioner	20,905.44
Total constructive average base period net income claimed
by petitioner	$ 62,614.00
Total claimed constructive average base period net income
from wine and miscellaneous operations	$ 20,928.82
Total claimed constructive average base period net income
from brandy	41,685.18
Total constructive average base period net income claimed
by petitioner	$ 62,614.00

Generally, the basis of petitioner's claim is that if it had started operations under the Fawver agreement in 1935, instead of 1937, its wine inventories would have been such that it would not have had to curtail its wine sales in 1938 and 1939 and it would have sold 20 per cent more wine in 1938 and 50 per cent more in 1939 than it actually did sell in those years, and if it had started producing commercial or beverage brandy in 1935, instead of 1937, it would, at the end of 1939, have been selling bottled brandy at the rate of 45,000 original proof gallons per year, and that if its base period net income is reasonably and properly reconstructed on the basis of the assumed increases in wine and brandy sales, its constructive average base period net income will be $ 62,614, as claimed.

It is not possible, on the record before us, to make any satisfactory determination as to the amount by which the petitioner's average base period net income would have been increased if it had commenced operations under the Fawver agreement in 1935, instead of 1937. As to wine, petitioner makes no claim that its sales or profits would have been any greater in 1936 and 1937 than they actually were. The increases in wine sales claimed for 1938 and 1939 are based on the testimony of the manager of the sales agency that in his opinion he could have sold 20 per cent more wine in 1938 and 50 per cent more in 1939 if he had had sufficient wine available. Also, seemingly by coincidence, petitioner's accountants have made their computation of constructive average base period wine net income on the same assumed increases in wine sales, the explanation being that if 1936 sales be regarded as normal and the ratio of petitioner's wine sales in 1936 to total apparent consumption of wine in the United States during that year be applied for 1938 and 1939 petitioner's sales for 1938, to be normal, should be 20 per cent higher and its sales for 1939, 50 per cent higher. *217 the general administrative and financing expenses. Except for a few minor items, which in reason would remain constant, such as the winery license fee, and others, such as commissions, which might be expected to increase ratably as volume increases, adjustments have been made ranging from those designated "normal increase" for most of the items under winery and cellar department and for numerous other cost items to as high as 179.67 per cent for 1939 bad debts, marketing and license tax, and cash discounts. Most of these adjustments are, so far as we are able to determine, based on the guesses and assumptions of the accountants, since we are unable to find any other basis therefor in the evidence of record.

Conceivably the petitioner has been quite conservative as to the "Direct Costs" (seemingly all costs exclusively attributable to wine, other than winery and cellar costs, bottling and labeling expense, and selling and shipping expense) applied to the assumed increased wine sales for 1938 and 1939. These costs are purportedly computed at the same rate per gallon as the "Direct Costs" to petitioner of the wine it actually did sell in those years and the rate applied is substantially in excess of the cost per gallon to petitioner for the Fawver 1937 vintage red wines as fixed by the written agreement of December 7, 1939. If, however, petitioner had started operations under the Fawver arrangement in 1935, instead of 1937, and had made the needed purchases under the oral agreement in 1938 and 1939, it would have been obligated to pay the current market price for such wines or an amount equal to the best offer Fawver might receive from some outside party. Petitioner has made no showing as to what the market price was for such wines if under such assumed circumstances purchases would have been made in 1938 and 1939 under the oral agreement.

Assuming, however, that the "Direct Costs" of Fawver wines in 1938 and 1939 would have been at least as low as the costs applied, and, aside from the unsupported assumptions of the accountants as to the adjustment of other cost items, we have a further difficulty with petitioner's claimed reconstruction of its wine profits, in that we are unable to conclude that the sales rate per gallon at which petitioner has constructed its assumed increased wine sales is realistic. The figure used is an average rate per gallon at which petitioner's combined sales of Los Hermanos and Mountain Ranch wines were made in 1938 and 1939. The facts show that generally it was the hope of the petitioner eventually to cease or greatly reduce its sales of wine under the Mountain Ranch label and sell all, or substantially all, of its wines under the Los Hermanos label. Presumably the production and sale of the Los Hermanos wines was the more profitable. The facts indicate that the cutback in wine sales in 1938 and 1939 was in sales under the Mountain Ranch label, and not in the sales under Los Hermanos. In such circumstances, the average of actual sales would give a greater per gallon rate than would be fitting and proper for bringing Mountain Ranch sales back to what would have been a normal level of Mountain Ranch sales in those years. Another factor which might well have some bearing on the matter is the showing that in 1938 and possibly in 1939 a goodly portion of the sales made under the Los Hermanos label were made from a blend of 32,000 gallons of aged wine and 100,000 gallons of new wine which had just been produced in the fall of 1937, preceding. Except for the fact that some difficulty was experienced with the wine so blended and sold, as illustrated by the Philadelphia situation, we are not advised as to the results. Undoubtedly the direct costs for the 100,000 gallons of new wine so used were considerably less than would have been the direct costs of wine which had been aged for two years or more. On the other hand, there is no indication or showing that the sales of the blend in question made under the Los Hermanos brand were not sold at the established Los Hermanos prices, which could mean that the margin of profit actually realized for such wine at Los Hermanos prices might well have been substantially greater than the margin of profit which would have been realized on the Los Hermanos wine which would have been sold from the usual blends of aged wines if the Fawver wines had been available two years before they were.

The circumstances being as they are, the record not only falls far short of substantiating the claims of the petitioner as to the amount by which its average base period net income should be reconstructed to reflect the wine sales which it would have had if it had started working under the Fawver arrangement two years earlier, but, in our opinion, is persuasive of a substantially lesser amount than the constructive average base period net income increase of $ 3,741 claimed. In that situation, we must make the best determination we can from the record before us, bearing most heavily against the petitioner, whose burden it was to prove the facts. Cohan v. Commissioner, 39 F. 2d 540. It is accordingly our conclusion, and we have found as a fact, that if petitioner's arrangement with Fawver had started 2 years earlier than it did, the average base period net income resulting from the increased wine sales in 1938 and 1939 would have been $ 2,000.

As to brandy, the petitioner rests its constructive average base period net income claim on assumed average base period sales of 45,000 original proof gallons of bottled beverage brandy and an assumed profit of $ 1.313 per gallon, before charges for general administrative and financing expenses. The claimed sales volume of 45,000 original proof gallons is in the fullest sense an assumed figure. So far as we are able to find, the only supporting evidence, and apparently the only evidence relied on by the petitioner, is testimony to the effect that Beringer, petitioner's president, in building the distillery, had settled upon 45,000 original proof gallons as the quantity of commercial or beverage brandy which petitioner would strive to produce and sell when its brandy business was established; and the testimony of the sales manager of Beringer Brothers Sales Agency, to the effect that in his opinion he could have been selling 4-year-old brandy at December 31, 1939, at the rate of 57,000 gallons per year, if such brandy had been available. The testimony as to the goal Beringer had in mind for the beverage brandy business requires no comment. Certainly it supplies no factual basis for reconstructing petitioner's brandy profits on assumed average base period brandy sales of 45,000 original proof gallons. As for the sales manager, we have only his bald assertion that in his opinion he could have been selling 4-year-old brandy at the end of 1939 at the rate of 57,000 gallons per year, and in light of various facts which have been established and the responses of the witness himself to questions on cross and redirect examination, the amount of assumed sales claimed is, so to speak, left dangling and unsupported in mid-air.

In the pleadings, we have not found any allegations that the claimed constructive average base period net income was based on claimed assumed sales of 4-year-old brandy. Also, one of petitioner's accountants, called as a witness was asked by the Court at the conclusion of his testimony, "Just to make sure the record is clear" whether "the reconstructed sales of brandy were reconstructed sales of two-year-old brandy," and he replied, without further explanation or qualification, "That is correct, reconstructed on the basis of sales of two-year-old brandy in 1939." On brief, however, the petitioner makes claim that by the end of the base period it would have been selling 4-year-old brandy at the rate of 45,000 original proof gallons per year, and for that reason its brandy profits should be reconstructed on assumed sales in the base period of 4-year-old brandy, rather than 2-year-old brandy. To support this claim, it points to the testimony of the sales manager as to the quantity of 4-year-old brandy which he thought he could have been selling at the end of the base period if it had been available. It is stated that the testimony of the accountant clearly had to do only with the rate at which the assumed base period brandy sales were reconstructed, in that petitioner being barred by the statute from using the results of its sales of 4-year-old brandy, all of which occurred after the base period, was limited, for reconstruction purposes, to its actual experience in selling 2-year-old brandy in 1939 and that it was in no way an indication that the reconstructed sales as claimed were reconstructed sales of 2-year-old brandy. It is to be noted at this point, however, that in the reconstruction of 1939 sales, about which the accountant was testifying, there were included as a part of the assumed sales of 45,000 original proof gallons 19,060 original proof gallons of brandy made for the Growers Grape Products Association in 1938 and which would not have been four years old until late 1940, even if it had been made in 1936, two years before it was.

Regardless, however, of whether the claim that its average base period brandy profits be reconstructed on assumed sales of 4-year-old brandy was or was not an afterthought, the reconstruction claimed still fails to find support in the facts of record. The petitioner made its first commercial beverage brandy in March or April of 1937 and if it had actually started such production 2 years before it did, it could not, until March or April of 1939, have had any 4-year-old brandy. In such case, it could have started selling 2-year-old bottled brandy in 1937, but the sales manager, who professed to being one of the best in the business, conceded that if he had started in 1937 he could not have sold in that year more 2-year-old or no-age brandy, or in fact more of any brandy less than 4 years old, than actually was sold in 1939 and that any increases in 1938 and 1939 sales of such brandy would have been only such nominal or gradual increases as would have been due to trade acceptance of petitioner's label. In such circumstances, and at such rate, the petitioner would have sold by May of 1939 approximately 5,250 original proof gallons of bottled brandy. In addition to the bottled brandy sold in 1939, the petitioner actually did sell in 1937, in one sale in bulk, 10,457 original proof gallons of its brandy made in that year. At the most, then, it could have had left in 1939 of the 33,895 gallons made in 1937 for its own account only 18,188 gallons which, with the 12,683 original proof gallons made in 1937 for Fawver's account, would have made 30,871 original proof gallons as the maximum amount of 4-year-old brandy which petitioner could have had available for sale at any time during 1939, or at any time during the base period.

On the record made, however, we do not believe that it may be reasonably or fairly concluded that the petitioner could in 1939 have sold the above brandy as 4-year-old brandy at a rate even approaching that contended for. According to the evidence, brandy production in California began with repeal of prohibition in 1933, and various producers were and would have been in the market some considerable time ahead of petitioner, even if it had started production in 1935. The facts show that 2,324,000 gallons of brandy were made in California in 1934, which was substantially the same as the average consumption of brandy in the United States for the years 1935 through 1939 and that brandy inventories in California as early as December 31, 1935, were close to double the apparent consumption of California brandy in the United States as a whole for all of 1935 and the inventories at December 31, 1936, and December 31, 1937, stood in substantially the same relation to apparent United States consumption of brandy for 1936 and 1937. The facts also show that apparent consumption of brandy in the United States in 1938 was not quite 85 per cent of what it had been in 1937 and that this drop, in the main, was in the consumption of California brandy. Such consumption did increase to some extent in 1939 over 1938, but 1939 consumption was still less than it had been in either 1937 or 1936. The sales manager testified that brandy is not one of the faster selling items in a liquor store and after the shelves are stocked it is difficult to introduce a new line or brand. The liquor store is not inclined to substitute a new and untried brand for a line of brandy which is already established, and can normally make room for a new line only by getting rid of its slowest moving brand, which is in and of itself a difficult thing, except at substantial sacrifice. He also testified that the main factor in launching the sale of the petitioner's brandy was the prestige of the name Beringer Brothers, but admitted that that effect was limited to those who had known Beringer products before prohibition. As to newcomers in the business, the name supplied no such leverage. Furthermore, it is to be noted that the brandy produced and sold by petitioner in the pre-prohibition days was very fine cognac brandy, made on a small scale in the pot still. It could not, in such circumstances, have had a very wide market. It is also obvious that the brandy made by petitioner from the Fawver wines in 1937, and which would have been 4 years old sometime during 1939, was not, in fact, quality brandy and could not have been sold as a counterpart of petitioner's pre-prohibition brandy. It was petitioner's purpose in reentering the beverage brandy field to manufacture and sell high quality brandy in keeping with the standard of its wines, and the brandy made in 1937 was not such brandy. The attempt at selling it as 2-year-old brandy in 1939 was prompted by petitioner's desire to get its label on the market as quickly as possible and the 1937 brandy was the best, in fact the only 2-year-old brandy, it had available for that purpose. Accordingly there is nothing in the record which in any way convinces us that even if petitioner had made the 1937 brandy in 1935 and had desired and intended to age it and sell it as bottled brandy, it could have sold such brandy as 4-year-old bottled brandy in 1939 at a rate of more than ten to twelve thousand gallons per year, if at that rate.

In addition to what has already been said above, there is little or no reason to believe that the petitioner would have carried any substantial portion of the brandy made in 1937 from the Fawver wines for the purpose of selling it as 4-year-old brandy in the bottled brandy market. In its claim for relief, petitioner gave as its reason for beginning the sale of the brandy in 1939 as 2-year-old bottled brandy its "financial inability to carry a supply of brandy through the full four years." It is also to be noted that in 1937 the petitioner made a bulk sale of 10,457 original proof gallons of the 33,895 gallons of brandy made for its own account in that year. Its reasons for making the sale were both because of its financial condition and because the brandy, having been made from wines of high acid contents, was not brandy of the quality which it desired to age and establish on the market. Although it had not up to the time of sale been required to pay for the wine used in making the brandy, it did have tied up in the brandy its costs of distilling and cooperage, and would be faced with subsequent costs of storing and aging; and in addition, it could not only get its money out of the brandy in question but it could make the sale at some profit. The petitioner's manager and winemaster testified that the 1937 brandy was fair, but not of the best, and that it was not until the fall of 1938, when it made brandy under the prorate plan and acquired right of purchase thereto, that brandy of the quality desired by petitioner for its brandy business became available to it. The prorate brandy was made "from new wines that were made from good grapes and low acids." If it had been made in 1936, instead of 1938, it would have been 2 years old in 1938, but would not have been 4 years old until late 1940. Bulk sales of brandy were not unusual in the industry and, on the facts shown, we think that more likely than not the petitioner, even though it may have had the selling of bottled brandy in mind when it built its distillery, would have sold the brandy made by it from the Fawver wines both for its own account and for Fawver's account in bulk sales as the opportunity offered, and not as bottled brandy, except such limited quantities as it might put on the market in its effort to get its label before the public pending the time when it would be in a position to bottle and sell brandy of the quality such as that which was made in 1938 under the prorate plan. It would not, in our opinion, have had any substantial amount of such brandy for sale in 1939 as 4-year-old brandy.

The petitioner makes some further claim that the rate of profit per gallon applied by the respondent in arriving at the constructive average base period brandy net income determined and allowed by him was intended and determined to be the profit per gallon actually realized by petitioner on the sales of 2-year-old bottled brandy made by it in 1939, that the profit per gallon actually realized by petitioner on such sales was, in fact, substantially higher, and, even though its claimed average base period sales of 45,000 original proof gallons be denied, it is still entitled, under the respondent's own determination that average base period sales would have been 33,368.81 original proof gallons, to constructive average base period brandy profits substantially in excess of the amount so computed and allowed. The respondent admits that the constructive average base period brandy net profits allowed by him were computed at a rate of 69 cents per gallon, and it does appear that the rate in question was the rate originally determined by a revenue agent as the actual profit per gallon realized by petitioner on its 2-year-old bottled brandy sales in 1939. The respondent contends, however, that the allowance as made in his final determination was on assumed base period sales of 2-year-old brandy, both bottled and in bulk, and that the rate per gallon used in arriving at the amount allowed was intended to cover both types of sales, and not only has the petitioner not shown that the combined rate for both bottled and bulk sales should have been higher, but it has not even shown just what net profits per gallon it is claiming for reconstruction purposes, since at no place in the presentation of its case does petitioner indicate what part of its general administrative and financing expenses should be charged to commercial brandy operations. Suffice it to say that it is our opinion and we have already stated our conclusion that constructive average base period brandy net profits have not been shown in any amount above the $ 20,779.74 allowed by the respondent.

Reviewed by the Special Division.

Decision will be entered under Rule 50.

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Footnotes

• 1. The record does not show when these brands were originated or adopted, the testimony being "that was our two brands" and "they had another label called Mountain Ranch." Whether or not the sales of the old wines and of the newer or younger wines prior to 1936 were made under the respective labels Los Hermanos and Mountain Ranch is not clear. In the stipulation, the two names are applied only to the sales in 1936 and later years, whereas the terms "old wine" and "new wine" are applied to the stipulated sales for 1934 and 1935. The footnote explaining this difference is not clear. It merely states that the petitioner's "wine inventory" before 1936 "was broken into two classifications: 'old wine' and 'new wine'," and further states that commencing with January 1, 1936, those classifications were dropped and thereafter the wine inventory was classified as Los Hermanos and Mountain Ranch "without regard to age." While it may be that the wine inventories as carried on the petitioner's books of account were not broken down as to age, but merely were designated Los Hermanos and Mountain Ranch, the testimony of petitioner's winemaster makes it clear that he at all times had the wine in storage segregated according to vintages and types of wine, except such wines as might already be in the blending tank for bottling and such as might have already been bottled.↩

• 2. The record contains no comparable breakdown of the wine inventories at January 1, 1937, 1938, or 1939. As to those inventories, schedules attached to petitioner's returns do, however, show the following:

  ↩

  Jan. 1, 1937	Gallons
  1936 purchases	79,376.26
  1936 production	13,917.00
  Mountain Ranch	144,997.00
  Los Hermanos	226,248.74
  Total	464,539.00
  Jan. 1, 1938
  1937 production	155,195.32
  Mountain Ranch	151,278.00
  Los Hermanos	148,694.71
  Total	455,168.03
  Jan. 1, 1939
  1938 production	159,570.00
  1938 purchases	23,881.00
  Mountain Ranch	144,999.98
  Los Hermanos	150,538.34
  Total	478,989.32

• 3. Certain actual or seeming differences between the stipulation and the testimony of witnesses are not explained. In the stipulation, the first column above is described as dry wine. The second column represents both dry and sweet wine. The difference in the gallonage shown as original production and final production is seemingly explained by a footnote in the stipulation that "in producing sweet wine a substantial amount of dry wine is required to produce the fortifying brandy used in making sweet wine. Sweet wine is fortified dry wine." The testimony of the petitioner's winemaster is to the effect that, in chief, the petitioner makes its fortifying brandy from "grape wash and higher acid wines." And while his testimony is to the effect that fortifying brandy is used in producing sweet wine, there is nothing in his testimony which would in any way support a conclusion that dry wine can be changed into sweet wine, by the addition of fortifying brandy. To the contrary, his explanation was that by the addition of fortifying brandy to sweet wine further fermentation of the sugar content of the wine into alcohol is arrested, thereby preserving in the wine the sugar at the level at which it stood when the fortifying brandy was added. See the prior finding on the matter, which finding is based on the winemaster's testimony.↩

• 1. In the stipulation, the sales for the years 1936 through 1940, as shown in these columns under old wine and new wine, were listed as Los Hermanos and Mountain Ranch, respectively.↩

• 4. The testimony in the record to the effect that the petitioner had an oral option with respect to all of the brandy produced by it for Fawver's account is somewhat similar to that relating to the oral option covering the wine produced at the Fawver winery during 1937, 1938, and 1939, under Abruzzini's supervision. The testimony is quite general, however, and the reason or necessity at August 1, 1939, for the written options as to the 1938 brandy only is not explained.↩

• 5. These figures have been stipulated by the parties. They have also stipulated that petitioner's 1939 sales of beverage brandy in bottles amounted to 2,250 original proof gallons. Petitioner bottles its brandy for sale at 90 proof. Presumably what had been 2,250 original proof gallons when the brandy was stored had been so reduced by evaporation during storage that it amounted to only 2,195.99 gallons at 90 proof when withdrawn and bottled. The record does not show what the proof of the 2,745.18 original proof gallons was at the time it was regauged for withdrawal and withdrawn.↩

• 6. In its claim for relief, petitioner gave its "financial inability to carry a supply of brandy through the full four years" as its reason for beginning the sale of 2-year-old bottled brandy in 1939. Petitioner resisted respondent's request for a finding to that effect, pointing to its purchase from Fawver in 1939 of the 12,683 gallons of brandy it had made for him in 1937. While such a purchase is a stipulated fact, it is to be noted that petitioner did not make any payment for the brandy at the time of purchase nor at any time during the base period.↩

• 7. The quantities shown are actually stated in terms of "tax gallons" which in turn, by a footnote, are said to be "substantially equivalent to proof gallons."↩

• 1. Includes 7,858,435 proof gallons of beverage brandy made in 1939 under the 1938 wine-grape prorate program.↩

• 8. See footnote 7 supra↩.

• 9. See footnote 7 supra↩.

• 1. The difference between 1938 excess profits net income and 1938 net profits according to petitioner's books results from respondent's disallowance of an item of $ 600 shown on the books as a worthless stock charge-off.↩

• 10. Sec. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.

  * * * *

  (b) Taxpayers Using Average Earnings Method. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be 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 --

  * * * *

  (4) the taxpayer, either during or immediately prior to the base period, commenced business or 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. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the purpose of this subparagraph, the term "change in the character of the business" includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, a difference in the ratio of nonborrowed capital to total capital, and 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. Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940. or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business. * * *↩

• 11. As shown in the findings of fact, petitioner experienced some difficulties with this batch of wine.↩

• 12. It may be noted in passing that while the consumption of wine in the United States for 1938 showed some increase over such consumption for 1937 the consumption of California wine in the United States in 1938 was substantially less in 1938 than had been the consumption of California wine in 1937.↩