Opinion
Docket No. 16300.
1949-04-22
KEYSTONE BRASS WORKS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Enoch C. Filer, Esq., for the petitioner. A. W. Dickinson, Esq., for the respondent.
1. Petitioner is a manufacturer of plumbing fittings. In 1941, due to the war program, its supply of raw material was restricted and later entirely extinguished. Consequently, petitioner abandoned its business. Almost simultaneously Packard, the only American manufacturer of Rolls-Royce aircraft engines, approached petitioner with the request that it engage in the production of bronze bushings to be used in that engine. The specifications demanded by the English designers of the engine provided for an unusual degree of hardness, chilled castings in permanent mold, and very close machine tolerances. No methods of production known to petitioner existed to enable it to meet such specifications. Therefore, it was compelled to rely on experimentation, research, and development of methods, means, and equipment to accomplish the desired end. It developed entirely new tools, special typed molds, mold coatings, dies, casting machines, special furnaces, new techniques, and new processes. The period of research and development extended through 1942, 1943, and a part of 1944. Petitioner expended large sums for such purposes during that period and finally solved the various problems of construction which continued to appear. It received gross income from the sale of the bushings in excess of the 125 per cent of the average amount of the gross income of the same class of the previous years, as required by section 721(a)(1), I.R.C. However, it was not able to attain the production stage until it had obtained and put in use certain standard equipment through Packard. Held, that a part of petitioner's gross income from the sale of bushings received in 1944 falls within class (C) income from research and development under section 721(a)(2)(C).
2. Amount of net abnormal income of taxable year to be attributed to prior years determined, giving due effect to all factors contributing to the income. Enoch C. Filer, Esq., for the petitioner. A. W. Dickinson, Esq., for the respondent.
The respondent determined a deficiency of $15,170.96 in the petitioner's income tax liability for the year 1942 and deficiencies of $424.01 and $54,060.42 in its income tax liability and its excess profits tax liability, respectively, for the year 1944.
The single issue is whether or not the petitioner is entitled to relief under the provisions of section 721(a)(2)(C) of the Internal Revenue Code, by reason of its having had abnormal income, of the class described in that section, attributable to prior years.
FINDINGS OF FACT.
The petitioner is a corporation, organized in 1917 under the laws of Pennsylvania, and has its principal place of business in Erie, Pennsylvania. It filed its income and excess profits tax returns for the taxable years with the collector of internal revenue for the twenty-third district of Pennsylvania.
Prior to 1941 the petitioner manufactured fittings for the plumbing industry; specifically, copper tube fittings, elbows, unions, and adapters. In the late fall of 1941, due to the war program, the petitioner was restricted in its use of copper for certain of its manufactured articles and in January of 1942 it was stopped completely in its manufacture of plumbing goods. The stoppage was continued until after August 10, 1945. Upon the cessation of its normal production, the petitioner undertook the manufacture of a number of items closely related to its peace time products, including terminal tubes or fittings for electrical cables on ships, tanks, and guns, which represented its heaviest initial war time production, and bronze shell caps.
In June 1940 Packard Motor Car Co., hereinafter referred to as Packard, undertook to manufacture Rolls-Royce aircraft engines for the British and United States Governments, according to specifications of Rolls-Royce of England. Such specifications, among other things, called for chilled cast or centrifugal chill cast bronze bushings, with very close machine tolerances.
Packard had never made bronze bushings. In October or November 1940, it established two sources of supply for such bushings, viz., Bunting Bronze & Brass Co. of Toledo, Ohio, hereinafter referred to as Bunting, and Federal-Mogul Corporation of Detroit, Michigan, hereinafter referred to as Federal. At that time, and prior thereto, Federal was engaged in the manufacture of bushings and bearings. Bunting had been engaged for some thirty years or more in the manufacture of bushings. Both had manufactured bronze bushings.
Federal and Bunting produced bushings for Packard in the early part of 1941. At first there was some dimensional difficulty, but that was corrected and thereafter their products were satisfactory.
In the latter part of 1941 Bunting and Federal were unable to meet the increased production of Packard, whereupon the latter looked around for other sources of supply of bushings. A representative of Packard contacted petitioner and inspected its plant. As a result, petitioner received from Packard three orders for 1,000 each of bushings, being orders Nos. 600626, 601643, and 604036, dated December 30, 1941. These orders were issued primarily to give petitioner a priority so that it could procure necessary machinery and materials. No shipments were made on such orders and they were later canceled.
Only a few pieces of equipment which petitioner had used for the production of plumbing fittings could be used for the production of bushings. Packard arranged for standard equipment, to be provided by the Defense Plant Corporation, on lease to petitioner, which included some grinders, precision boring machines, turret lathes of various types, and some melting furnaces. Petitioner also purchased some equipment.
Prior to the receipt of the above mentioned orders, petitioner began its experiments to produce a sample bushing satisfactory to Packard.
The specifications required, among other things, a hardness of 80 on the scale established to measure the softness of metal, chilled castings by the permanent mold or centrifugal process, and a tolerance of 2 1/2 ten-thousandths to 5 ten-thousandths of an inch on a surface of 15 micro inches, or the limitation of the mean depth of a scratch to not over 15 millionths of an inch. Both the required degree of hardness and the limited tolerances were very unusual and had not been specified prior to the war. The bushings were in reality bearings which supported a rotating shaft. They were critical parts of the engine. In recognition of this fact, the English designers specified the high degree of hardness. The type of chilled castings was used in the United States only by Packard.
The common molding process is to mold in sand, which mold is destroyed after each casting. A permanent mold is made out of steel or semi-steel and alloy iron. When the hot metal is poured against the cold permanent mold, the metal is chilled rapidly, thus increasing the hardness of a casting. Bushings made by such process were vastly different from the goods manufactured by the petitioner prior to 1941. The petitioner had never made bushings prior to that date.
Permanent mold castings had been made in the United States prior to 1941. However, permanent mold chill casting was a new art, originated in England as a result of tests made with the Rolls-Royce engine.
The petitioner consulted with many manufacturers whom it thought might have information relating to the proper methods of meeting the specifications for chilled casting and finally secured the services of an editor of the Foundry Magazine who was an authority on nonferrous foundry practices. He maintained that it was not possible to make bushings of the size and type required, by the permanent mold method. After considerable discussion with Packard, the petitioner in February 1942, hired an engineer who had had experience in permanent mold work, but who had never heard of chill bronze castings, as such. The petitioner's officers and the engineer made an initial permanent mold, but the castings made therefrom were not up to specifications. The petitioner then made a vacuum type of mold, requiring the building of a special furnace. It found that the turbulence created by pouring hot metal into such a mold produced a defective casting. It then built a mold, immergeable into a crucible and intended to function with the aid of a vacuum pump, but the essential air exhaust valve was jammed by the heat of the metal, and that type of mold was abandoned. During 1942 the petitioner made further experiments involving ten different molds, mold changes, and special furnaces.
The petitioner also experimented with ‘gating‘— or the introduction of the hot metal into the mold— without creating turbulence or chilling the metal during its flow. Finally, sand was placed in the sprue areas, thus keeping the metal warm until it reached the bottom of the mold cavity. Satisfactory results were obtained by using this procedure. The petitioner further was compelled to experiment in the use of mold material in order to obtain a mold metal which would have a sufficiently higher melting point than the casting and thus attain durability. Such experimentation continued until about the middle of 1943. It was necessary for the petitioner to develop expert metal workers.
The petitioner, by experimentation, produced special types of molds, tools, mold coatings, dies, casting machines, special furnaces, and other needed equipment.
The petitioner also experimented extensively with mold-coating material, and in the latter part of 1944 discovered a formula containing, among other things, graphite and tapioca, which insured a quick chill and no blow holes. Thus a satisfactory casting was produced.
In 1943 Packard required that certain castings be made by the centrifugal process, with the same chill specification. A centrifugal casting is made by spinning the mold containing the hot metal; the heavier metal is drawn to the outside, and the impurities, lighter in weight, are held to the inside and ultimately machined out of the center. The petitioner thus was forced to undertake further experimentation and development. No centrifugal castings as small as those required by Packard had been made in the United States and no producer of centrifugal castings would furnish the required small castings to the petitioner. The development ceased after the middle of 1944.
The petitioner attempted to secure information and suggestions relating to both the chilled and the centrifugal castings from Bunting and Federal, but they refused to divulge their secrets, if any, to either Packard or to the petitioner.
By October 1942 a satisfactory sample of bushing No. 600626 was produced. Thereupon, petitioner received an order from Packard for 216,000 bushings No. 600626. Petitioner delivered 767 of such bushings to Packard in 1942. Some other satisfactory samples were produced and Packard placed with the petitioner additional orders, dated in 1942, calling for 634,500 bushings of various designated numbers.
In the following letter written by petitioner, addressed to Packard and dated November 17, 1943, petitioner sums up its experiences to that date. It reads, in part, as follows:
As our letterhead indicates, we were— prior to the war— manufacturers of brass fittings for the plumbing trade. We made the castings for these fittings in our own foundry using sand exclusively and machined them in our own machine shop, such work calling for no close tolerances or fine surface finish.
Desiring to devote our facilities to war work, we started in 1941 to solicit subcontracts from the various automobile manufacturers and in this connection first talked with your Mr. Drake in November 1941. At that time your company was urgently in need of an additional source of supply for bronze bushings due to the fact that the established bushing manufacturers were unable to meet the total requirements for airplane engine bushings and Mr. Drake gave us several blue prints illustrating types of bushings required.
A study of these prints indicated that castings for such bushings must be made by the permanent mold method in which we had had no experience and that they called for machining within very close tolerances and with extremely fine surface finish— both features far beyond any experience we had had. Our situation in this respect was not peculiar to us because aside from the established bushing manufacturers, no one was experienced in this type of manufacture.
We advised Mr. Drake that we were willing to start experimental work to see if we could demonstrate to his satisfaction and our own our ability to do this type of work. We employed a man of long experience in the manufacture of permanent mold castings and made permanent molds of several sizes. We placed an order for one machine to produce the necessary tolerances and surface finish and while waiting many months for delivery of this machine completed our preparations for all other phases of this experimental work. By October 1942 this machine was in our plant and we had produced satisfactory samples of your part 600626. This one machine gave us a capacity of 8000 pieces per month of this one part.
On October 6, 1942 Mr. Drake asked us to get a delivery promise on 4 additional machines of the same type so that our capacity on part 600626 could be increased to 40,000 pieces per month. We learned that these additional machines could be delivered in January 1943 and expressed a willingness to purchase these machines. On October 9, 1942 Mr. Drake asked us to consider a much larger program of bushing manufacture based on Defense Plant Corporation machinery being placed in our plant and covering 10 additional part numbers, with monthly requirements of 64,285 pieces in addition to the 40,000 pieces per month of part 600626.
After giving this matter careful consideration we advised Mr. Drake on October 17, 1942 that we would be willing to undertake the manufacture of 7 of the 10 new part numbers, which with part number 600626 would make a total of 8 parts, with a total monthly requirement of 83,385 pieces and on that date submitted a list of Defense Plant Corporation machinery which would be required for such a program, qualified by the statement that some additions and alterations in this list of equipment might be necessary as the program developed. On October 22, 1942 Mr. Drake confirmed the fact that Defense Plant Corporation equipment would be supplied.
Many months elapsed before the Defense Plant Corporation machinery was delivered and installed in our plant and in the meantime our personnel was being trained in the requirements of bushing manufacture through the production of part 600626 which was the only part we were equipped to make prior to receipt of the new machinery.
In November and December 1942 Mr. Drake asked us to add 15 additional part numbers to our program, and although all of these could not be accepted, we did accept 13 bringing our total list of part numbers to 21 as indicated in our quotation letter of today in contrast with the 8 part numbers in our program at the time we made up our list of required machinery.
Careful study of the expanded program indicated that our original list of machinery should be supplemented with either Heald Boromatic Machines or Ex-Cell-O Boring Machines, together with grinding equipment, and beginning in January 1943 we endeavored to have such equipment added to that previously specified. Such efforts on our part were met with the statement that it was simply impossible to get equipment of this sort under existing conditions and that we would have to do the best we could with the original list of equipment. After repeated appeals on our part your Mr. Froehlich did succeed in arranging for us to receive one Ex-Cell-O Boring Machine which was shipped on July 14, 1943, after which more than a month as required for delivery, installation, and tooling.
In the middle of July 1943 your Mr. Gusick spent 3 days at our plant and after making a very careful study of the situation recommended to your Mr. Froehlich on July 17, 1943 the addition of one Cincinnati Centerless Grinder, 2 Landis Grinders, and one additional Ex-Cell-O Boring Machine to our equipment, as he was convinced we could not satisfactorily produce the bushings called for on your purchase orders without this additional equipment. Your Mr. Froehlich immediately went to work on this proposition with the result that this additional equipment has been supplied— the final item having been received within the past 10 days.
Our shipments of bushings in recent months have increased as the additional equipment was brought into service, as indicated by the following tabulation:
+-------------------------------+ ¦ ¦Pieces per ¦ +-----------------+-------------¦ ¦ ¦working day ¦ +-----------------+-------------¦ ¦ ¦ ¦ +-----------------+-------------¦ ¦August ¦498 ¦ +-----------------+-------------¦ ¦September ¦660 ¦ +-----------------+-------------¦ ¦October ¦848 ¦ +-----------------+-------------¦ ¦November to date ¦1,151 ¦ +-------------------------------+
Up to the present time this Packard bushing program has resulted in our suffering an actual loss of many thousands of dollars. It was necessary for us to build an addition to our plant to accommodate all of the bushing equipment. We have had a tremendous expense in the training of employees for this work and it has been necessary for us to make some expense changes in supervisory personnel. Our costs for tooling have been heavy. Due to lack of experience and during the period when we did not have a rounded list of equipment we have produced thousands of pieces of scrap. Over a period of more than a year our production has been limited, giving us no opportunity to offset these expenses. Under these circumstances we feel that our prices must be maintained at the present level until such time as we have had enough months of full production to enable us to regain the losses experienced to date.
We have every confidence that with steady capacity production we can regain these losses and then be in a position to make price reductions as a result of full production on equipment suited for this work. * * *
Packard was required by the Army Air Corps to furnish many thousands of spare parts for the aircraft engines which were to be used throughout the whole world. Packard's orders were given to the petitioner to cover the anticipated need of bushings as spare parts. In the latter part of 1943 or early part of 1944, after the supply depots had received a generous supply of spare parts, the demand for spare parts fell off one-half or more of the original demand. This was reflected in cancellation of orders.
The following schedule shows, in number of bushings, all orders and cancellations thereof by Packard issued to petitioner each year and shipments made by petitioner to Packard for the entire period during which petitioner manufactured bushings for Packard:
+-----------------------------------------------------------------------+ ¦ ¦1941 ¦1942 ¦1943 ¦1944 ¦1945 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Orders at start of year ¦ ¦3,000 ¦793,733 ¦305,477¦187,925 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦New orders received ¦3,000¦850,500¦318,675 ¦603,805¦228,027 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Total orders ¦3,000¦853,500¦1,112,408¦909,282¦415,952 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Cancellations: ¦ ¦ ¦ ¦ ¦ ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦1941 orders ¦ ¦1,000 ¦2,000 ¦ ¦ ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦1942 orders ¦ ¦58,000 ¦465,435 ¦8,322 ¦26 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦1943 orders ¦ ¦ ¦135,504 ¦27,389 ¦900 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦1944 orders ¦ ¦ ¦ ¦92,377 ¦34,414 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦1945 orders ¦ ¦ ¦ ¦ ¦178,519 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Total cancellations ¦ ¦59,000 ¦602,939 ¦128,088¦213,859 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Orders less cancellations ¦3,000¦794,500¦509,469 ¦781,194¦202,093 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Shipments during year ¦ ¦767 ¦203,992 ¦593,269¦* 200,336¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Orders at end of year ¦3,000¦793,733¦305,477 ¦187,925¦1,757 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Overshipped on some orders ¦ ¦ ¦ ¦ ¦1,459 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Unfilled orders ¦ ¦ ¦ ¦ ¦3,216 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦1944 order canceled in 1947¦ ¦ ¦ ¦ ¦2,997 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦Due on two 1942 orders ¦ ¦ ¦ ¦ ¦219 ¦ +---------------------------+-----+-------+---------+-------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------+
FN* This number represents the difference between total number of bushings received by Packard of 998,364, including overshipment 1,459, and total shipped to Packard by petitioner in 1942 through 1944 of 798,028. The evidence does not show that this entire number was shipped in 1945.
The number of Rolls-Royce aircraft engines produced by Packard from 1940 through 1945 was as follows:
+------------+ ¦1940¦none ¦ +----+-------¦ ¦1941¦47 ¦ +----+-------¦ ¦1942¦7,253 ¦ +----+-------¦ ¦1943¦12,295 ¦ +----+-------¦ ¦1944¦22,969 ¦ +----+-------¦ ¦1945¦12,561 ¦ +----+-------¦ ¦1941¦55,125 ¦ +------------+
The petitioner delivered to Packard 767 bushings in 1942, 203,992 in 1943, and 593,269 in 1944, for the respective sums of $575.86, $165,587.34, and $571,896.17. The petitioner's income therefrom in 1944 was more than 125 per cent of the average amount of its gross income from the same class for the four previous years.
The unit price of the bushing was gradually reduced throughout the entire program. No portion of the petitioner's income in 1944 from the manufacture of bushings was attributable to decreased operation costs.
The petitioner computed 1941 net abnormal income from development and allocated it to 1944, 1943, and 1942 as follows:
+------------------------------------------------------------------------+ ¦ ¦1942 ¦1943 ¦1944 ¦ +--------------------------------------+---------+-----------+-----------¦ ¦ ¦ ¦ ¦ ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Net Sales from Development ¦$575.86 ¦$165,587.34¦ ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Normal Cost to Manufacture ¦82.84 ¦44,349.68 ¦ ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Income from Development ¦493.02 ¦121,237.66 ¦ ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Average Income from Development ¦ ¦ ¦$30,432.67 ¦ +------------------------------------------------+-----------+-----------¦ ¦125% of Average Income from Development ¦ ¦$38,040.84 ¦ +------------------------------------------------+-----------+-----------¦ ¦Net Sales for 1944 from Development ¦ ¦ ¦594,720.62 ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Reduction by Renegotiation ¦ ¦ ¦22,824.45 ¦ +------------------------------------------------+-----------+-----------¦ ¦Net Sales for 1944 after Renegotiation Deduction¦ ¦571,896.17 ¦ +------------------------------------------------+-----------+-----------¦ ¦Cost to Manufacture in 1944 ¦ ¦ ¦267,983.98 ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Gross Income from Development—1944 ¦ ¦ ¦303,912.19 ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Less 125% of Average Income ¦ ¦ ¦38,040.84 ¦ +------------------------------------------------+-----------+-----------¦ ¦Gross Abnormal Income from Development ¦ ¦265,871.35 ¦ +------------------------------------------------------------+-----------¦ ¦Total Selling & Adm. Costs ¦$112,053.69 ¦ ¦ +--------------------------------------+---------------------+-----------¦ ¦Gross Income from Development ¦303,912.19 ¦ ¦ +--------------------------------------+---------------------+-----------¦ ¦ ¦-------------=95.5% ¦ ¦ +--------------------------------------+---------------------+-----------¦ ¦Total Gross Income ¦318,377.54 ¦ ¦ +------------------------------------------------------------+-----------¦ ¦Percentage of Selling & Adm. To Income from ¦ ¦ ¦ +------------------------------------------------+-----------+-----------¦ ¦Development—95.5% ¦ ¦ ¦ ¦ +--------------------------------------+---------+-----------+-----------¦ ¦95.5% of $112,053.69=$107,011.28 ¦ ¦ ¦ ¦ +--------------------------------------+---------------------+-----------¦ ¦Gross Abnormal Income from Development¦265,871.35 ¦ ¦ +--------------------------------------+---------------------+-----------¦ ¦ ¦-------------=87.5% ¦ ¦ +--------------------------------------+---------------------+-----------¦ ¦Gross Income from Development ¦303,912.19 ¦ ¦ +------------------------------------------------------------+-----------¦ ¦Percentage of Selling & Abnormal Income ¦ ¦ ¦ +------------------------------------------------+-----------+-----------¦ ¦from Development—87.5% ¦ ¦ ¦ ¦ +--------------------------------------+---------+-----------+-----------¦ ¦87.5% of $107,011.28=$93,634.89 ¦ ¦ ¦93,634.89 ¦ +------------------------------------------------+-----------+-----------¦ ¦Net Abnormal Income from Development ¦ ¦$172,236.46¦ +------------------------------------------------+-----------+-----------¦ ¦Actual Cost to Manufacture ¦$7,709.92¦$173,619.38¦$267,983.98¦ +--------------------------------------+---------+-----------+-----------¦ ¦Normal Cost to Manufacture ¦82.84 ¦44,349.68 ¦176,793.34 ¦ +--------------------------------------+---------+-----------+-----------¦ ¦Development Expense ¦7,627.08 ¦129,269.70 ¦91,190.64 ¦ +--------------------------------------+---------+-----------+-----------¦ ¦ ¦ ¦ ¦ ¦ +------------------------------------------------------------------------+
Development Expense Percentage Apportionment 1942 7,627.08 3.3% 5,683.80 1943 129,269.70 56.7% 97,658.07 1944 91,190.64 40.0% 68,894.59 Totals $228,087.42 100.0% $172,236.46
In his notice of deficiency the Commissioner determined that in computing its excess profits tax liability for the taxable year 1944 petitioner had no net abnormal income attributable to other taxable years.
The petitioner's net abnormal income for the year 1944 was $120,565.52, which is attributable to the extent of $68,360.65 to 1943 and $3,978.66 to 1942.
OPINION.
VAN FOSSAN, Judge:
The issue before us is whether or not the petitioner may be granted the benefit of section 721(a)(2)(C) of the Internal Revenue Code
because it had abnormal income in the taxable year, of the class set forth in that section, attributable to prior years.
Decision with respect to excess profits tax liability for 1944 will be entered under Rule 50. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.(a) DEFINITIONS.— For the purpose of this section—(1) ABNORMAL INCOME.— The term ‘abnormal income‘ means income of any class includible in the gross income of the taxpayer for any taxable year under this subchapter if it is abnormal for the taxpayer to derive income of such class, or, if the taxpayer normally derives income of such class but the amount of such income of such class includible in the gross income of the taxable year is in excess of 125 per centum of the average amount of the gross income of the same class for the four previous taxable years, the taxable years during which the taxpayer was in existence.(2) SEPARATE CLASSES OF INCOME.— Each of the following subparagraphs shall be held to describe a separate class of income:(C) Income resulting from exploration, discovery, prospecting, research, or development of tangible property, patents, formulae, or processes, or any combination of the foregoing, extending over a period of more than 12 months; * * *
(b) AMOUNT ATTRIBUTABLE TO OTHER YEARS.— The amount of the net abnormal income that is attributable to any previous or future taxable year or years shall be determined under regulations prescribed by the Commissioner with the approval of the Secretary. In the case of amounts otherwise attributable to future taxable years, if the taxpayer either transfers substantially all its properties or distributes any property in complete liquidation, then there shall be attributable to the first taxable year in which such transfer or distribution occurs (or if such year is previous to the taxable year in which the abnormal income is includible in gross income, to such latter taxable year) all amounts so attributable to future taxable years not included in the gross income of a previous taxable year.
The picture presented is that of a small but efficient manufacturer of plumbing fittings called upon to produce bronze bushings for Rolls-Royce aircraft engines— under specifications and requirements theretofore wholly unknown to the petitioner. That the new and untried field of operation demanded much experimentation and development can not be gainsaid. Going beyond the range of its previous experience and knowledge and the scope of its contemporaneous advice, suggestions, and instructions, the petitioner was forced to overcome, by exploration, trial, and research, currently considered impossible obstacles in order to produce the articles required by Packard and demanded by the exacting specifications of the English designed aircraft engine.
The three most important requirements imposed by Packard were (1) an extraordinary degree of hardness, (2) chilled castings by the permanent mold method, and (3) a finish tolerance limited to 15 millionths of an inch in mean depth. Later, the problems of mold coating and centrifugal casting complicated the situation and their solution required further research, experimentation and development. There were no methods of manufacture known to the petitioner or obtainable by it whereby it could meet such unusual exactness and precision of construction. Consequently, new processes, new equipment, and new techniques had to be developed in usable form to accomplish the desired result.
At the outset, we must keep in mind the fact that the petitioner's operations during the years under consideration were confined within very narrow limits. It had abandoned entirely its normal manufacture of plumbing fittings and was undertaking a new, unfamiliar, and untried procedure, consisting of the production of a particular type of bushing to be used in the Rolls-Royce aircraft engine, which was being built by only one manufacturer, Packard. The petitioner was confronted by a blank wall of inexperience in the peculiar new art which was to be responsible for the creation of the needed bushing, and was challenged by precisely the kind of necessity which has so often been the mother of American invention.
The record reveals clearly that the statutory and the regulatory requirements have been met by the petitioner. The research and development required to perfect the process of manufacture extended over a period of considerably more than twelve months. The petitioner's abnormal income in 1944 was not the result of increased prices, low operating costs, decreased competition, or improvement in business conditions.
The respondent quotes from Soabar Co., 7 T.C. 89, to the effect that the two major purposes of enacting the excess profits legislation were to provide additional revenue and to prevent the creation of war millionaires, and emphasizes the following excerpt:
* * * Congress anticipated that business for many taxpayers would improve because of external changes and it intended the tax to apply in those cases. It also realized that there might be some instances in which the income of the base period years might not satisfactorily reflect internal changes in the business. That is, there might be cases in which the increase in profits of the tax year over those of the base years might be attributed, at least in part, to internal changes and development of a particular business or some phase of that business to its full stature and to that extent would not be attributable to the outside business stimulus. * * * and then concludes:
Viewing section 721(b) in the light of the foregoing, it would seem that Congress intended to extend relief only when the abnormal income described in section 721(a)(2)(C) constituted the fruition of the initiative and enterprise of the taxpayer in engaging in original research and development.
In our opinion, both the excerpt and the respondent's conclusion fit precisely the facts in the case at bar. The law does not mean that an article itself must be an entirely new product, but it may be a new type of the article or an improvement therein which necessitates original research and development of tangible property and the processes of manufacture, and which results in the abnormal income defined in section 721(a)(1). See W. B. Knight Machinery Co., 6 T.C. 519; Rochester Button Co., 7 T.C. 529.
The respondent treats the record as showing that the petitioner merely ‘adapted‘ its plant to wartime requirements. The Defense Plant Corporation provided certain standard machinery needed for bushing manufacture, but the petitioner invented, designed, and developed particular equipment essential to its research, experimentation, and production, such as molds, tools, dies, casting machines, and special furnaces. Such equipment bore no relation whatever to the petitioner's prewar activities. Due to Government restrictions and prohibitions, the petitioner was compelled to abandon its normal business. Fortunately for it, it secured from Packard the opportunity to develop the needed bushing. Here, as in W. B. Knight Machinery Co., supra, the work of experimenting and developing constituted a radical departure from the art and methods of manufacture employed by petitioner theretofore, and it thus produced a new and different product having little or no relation to its old products.
However, the income derived in 1944 from the sale of the bushings was not the result in its entirety from research or development, as contended by petitioner. Some part of such income was due to efficient management and the skillful use of machinery in the plant, as well as the use of new machinery and equipment acquired by petitioner without which it could not have produced the quantity produced in 1944. Ramsey Accessories Mfg. Corporation, 10 T.C. 482. Some part of such income is also due to increased demand. It is true that petitioner received orders for a greater number of bushings in 1942 than in 1944,but more than one-half in number of bushings of the 1942 orders were canceled in 1943 due, in part, to a reduction in demand for spare parts. The number of bushings ordered in 1944 was substantially in excess of the number ordered in 1943. It is to be noted, too, that the number of engines manufactured by Packard was greatly in excess of the number manufactured in prior years. Therefore, a certain portion of the income derived from the sale of bushings does not come within the intendment of the statute. Eitel-McCullough, Inc., 9 T.C. 1132.
The period of research and development extended into 1944. This is conceded by petitioner, for it allocated $68,894.59 of its net abnormal income as computed by it to 1944. The respondent argues that, although petitioner kept a record as to materials and labor which went into the bushings, there was no breakdown in such records of materials, labor, manufacturing, and overhead as between research or development and production, and that, therefore, petitioner, in attempting to sustain its burden of establishing its net abnormal income and the amount thereof attributable to prior years, was ‘forced to indulge in reconstruction based on estimates.‘ He does not suggest that the estimates or reconstruction were unreasonable or without basis. As stated in Rochester Button Co., supra, ‘it is easy to understand that a taxpayer's books are not kept with prophetic vision as to the future requirements of income tax legislation.‘ Here, as in that case, ‘the burden of going forward with any possible contradictory material reasonably fell upon respondent.‘
We have observed that it is difficult to make precise allocation of amounts of income attributable to various factors or periods. Ramsey Accessories Mfg. Corporation, supra. After considering all the evidence, it is our conclusion that petitioner's net abnormal income for the year 1944 is attributable to the extent of $68,360.65 to 1943 and $3,978.66 to 1942, and we have so found.
Reviewed by the Special Division.