Kaufman, Anderson and Oakes, Circuit Judges.
This is an appeal by Briarcliff Candy Corp. (taxpayer), formerly Loft Candy Corp. (Loft), from a decision of the Tax Court which held that substantial expenditures made by Loft in the tax year July 1, 1961 to June 30, 1962, in developing a market for the sale of its candy to wholesale customers were made to acquire a capital asset, 26 U. S. C. § 263(a) (2), and not deductible as ordinary and necessary business expenses under 26 U. S. C. § 162(a).
The Loft Candy Corp. and its predecessors had, since late in the 19th century, engaged in the manufacture and sale of candy and confectionery products. More than 80% of its sales were made through its own retail stores, and the rest were through wholesale customers. Its retail stores were located in the thickly populated urban centers in the northeastern part of the country.
During the 1950's there began in this country, particularly in the northeast, a major demographic phenomenon in the form of a population shift of thousands of people from the urban centers to the suburbs. This gave and has continued to give rise to very serious problems for municipal, state and the federal governments, many of which still remain unresolved. The social and economic consequences have been far reaching; and urban centered businesses, large and small, have been compelled to take measures to meet the change, in the interest of survival.
In response to the effect of this exodus, the taxpayer at first sought to retain the numbers of its customers by opening retail candy stores in the suburbs but each such outlet could only attract a fraction of the sales volume achieved by the stores in the urban centers, which resulted in proportionately higher operating cost and a lower profit margin. Its operating profits for the fiscal years ending June 30, or thereabouts, of 1958 through 1961 were as follows:
In the latter part of 1961 taxpayer's management instituted a program of soliciting independently operated retail outlets such as drugstores, card stores and the like, to include in their businesses the retail sale of Loft's candies. Taxpayer, in its own organization, set up a separate "franchise" division headed by a vice president and staffed with a sales manager, several salesmen and clerical personnel. Its task was to persuade these storekeepers to take on the retail sale of Loft's candies, to enter into agency or franchise contracts with them, specifying the terms under which candy would be furnished at wholesale by taxpayer and handled and sold by the retailer, and to see that the contracting stores were properly serviced and had a proper flow of merchandise. In each of these contracts the retail store proprietor agreed to set aside a space in the store for refrigerating display and storage counters at his own expense, to be exclusively devoted to the sale of Loft candies, and to use his best efforts to sell these candies to his customers. Taxpayer agreed to supply the retailer with its candies at a discount from retail prices and to assist the proprietor in setting up and operating the facility. It also agreed not to enfranchise a competing drugstore within a specified area. The contracts remained in operation for terms varying from one to five years and after the initial term, it was to continue from year to year unless terminated by one party giving 30 days notice to the other.
Beginning in the latter part of 1961, the franchise division of the taxpayer embarked upon an extensive advertising campaign. It advertised in drugstore trade journals and circularized proprietors by mail to interest them in becoming a retail outlet for taxpayer's products. In the tax year ending June 30, 1962, it mailed circulars, with attached reply cards to 50,000 independent drugstores. The 2,000 response cards received were followed up by telephone calls and personal visits by salesmen. By June 30, 1962, 600 appointments were arranged and 159 contracts were entered into.
The net expenses incurred by the taxpayer in operating the franchise division for the taxable year ending June 30, 1962 were $332,869. The Commissioner divided the items making up this total into two categories of expenses which he labeled, "Promotional Expenses" and "Recurring Operational Expenses."*fn1 The promotional expenses aggregated $212,028, and these he disallowed as part of taxpayer's claimed net operating loss carry back from the taxable year ended June 30, 1962 to the taxable year ended June 27, 1959. The Commissioner's action was upheld by the Tax Court and the taxpayer has appealed. We reverse.
On May 3, 1971, the taxpayer sold its business to Barricini Stores Inc. The history of taxpayer's franchise division between year ending June 30, 1962 and the date of the sale of the business is significant and of interest. The following shows the agencies opened and closed during each year through June 1968, and the number in operation at the end of each year through June, 1969:
Agencies Agencies ing at close
Taxable year opened closed of tax year
June 26, 1965 415 75 1,186
July 2, 1966 268 74 1,380
July 1, 1967 112 132 1,360
June 27, 1968 195 90 1,465
Of the original 159 agencies in operation on June 30, 1962 about 120 were continuing to sell Loft's candies on June 28, 1969.*fn2 The taxpayer's management, however, decided by January 1, 1969 that the returns from the franchise division were not sufficient to compensate for the administrative problems and particularly the restrictions (such as territorial restrictions) with which it was burdened under the agency contracts, and it therefore determined to terminate the agency contracts as soon as it could under their terms. The entire expenditures for and efforts of the franchise division made very little change in net sales. In the fiscal years 1958 through 1970 the net sales were as follows:
Fiscal year Division Other ...