Rev. Rul. 54-585

Advice has been requested as to the meaning of the word `substantial' as used in section 433(b)(10)(C)(i) of the Internal Revenue Code of 1939, applicable to the taxable years ended after June 30, 1950, and beginning prior to January 1, 1954, and its effect, if any, on the applicability of the decisions in Iron Fireman Manufacturing Company v. Commissioner , 5 T.C. 452, acquiescence C.B. 1945, 4, and Denman Tire and Rubber Company v. Commissioner , 14 T.C. 706, acquiescence C.B. 1950-2, 2, which were based upon section 711(b)(1)(K)(ii) of the Code of 1939, applicable to taxable years beginning after December 31, 1939, and prior to December 31, 1945.

Section 711(b) provided for adjustments in computing the average base period net income for excess profits tax purposes. Subparagraphs (H), (I), and (J) of section 711(b)(1) provided for the disallowance of certain abnormal deductions in computing the average base period net income, and section 711(b)(1)(K)(ii) provided that for the purposes of subparagraphs (H), (I), and (J)-

(ii) Deductions shall not be disallowed under such subparagraphs unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.

Section 433(b)(10) of the Code, applicable to the taxable years ended after June 30, 1950, and beginning prior to January 1, 1954, which prescribed the rules with respect to the disallowance of certain classes of abnormal deductions described in paragraph (9) of that section, provided in part, as follows:

(C) Deductions of any class shall not be disallowed under such paragraph unless the taxpayer establishes that the increase in such deductions-

(i) is not a cause or a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, which increase or decrease is substantial in relation to the amount of the increase in the deductions of such class, * * *. Italics supplied.

In Iron Fireman Manufacturing Company, supra , where the taxpayer contended that its base period net income should be increased by the disallowance of alleged abnormal deductions in 1937 and 1938 for replacement expenses, occasioned in part by defects in anthracite and `coal flow' stokers, the court held that since the expenditures varied from year to year in a reasonably constant proportion to sales, with high points being reached in years when new models were being tried out, and the taxpayer was unable to show that none of the excess or alleged abnormal expenditures was a consequence of an increase in gross income, it was not entitled to relief under section 711(b)(1)(K)(ii) of the Code.

In Denman Tire and Rubber Company, supra , where it was found that the business of the taxpayer has been very considerably improved and expanded, the court held that the taxpayer had not shown that certain amounts expended for advertising, professional services, factoring commissions and repairs were not due in part, at least, to some of the limiting factors enumerated in section 711(b)(1)(K)(ii) of the Code. The taxpayer's contentions were, therefore, denied.

The words `substantial' and `very considerably' as used by the courts in the above cases refer to a `large' portion of the increase in gross income and a `large' improvement and expansion. While this is apparent in view of the facts, it is also apparent on the basis of the fundamental principle that words are to be accorded their normally accepted meaning in the absence of a showing of contrary intent.

However, the word `substantial,' as used in section 433(b)(10)-(C)(i) of the Code, is modified by the phrase `in relation to the amount of the increase in the deductions of such class;' therefore, it means `proportionately large.' Consequently, it has no effect on the applicability of the decisions in Iron Fireman Manufacturing Company, supra , and Denman Tire and Rubber Company, supra . The decisions in these cases are applicable in any case arising under section 433(b)(10)(C)(i) of the Code, in which it has not been shown that the increase in expenditures is not attributable to a proportionately large or substantial increase in gross income.