Toledo Eng'g Co. 
v.
Comm'r of Internal Revenue

Tax Court of the United States.May 5, 1950
14 T.C. 765 (U.S.T.C. 1950)
14 T.C. 765T.C.

Docket No. 19520.

1950-05-5

THE TOLEDO ENGINEERING CO., INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Richard S. Cole, Esq., and A. J. Beran, C.P.A., for the petitioner. John A. Newton, Esq., for the respondent.


1. Petitioner specializes in the engineering, design, and construction of glass plants and allied equipment. From 1936 to 1943 petitioner was actively engaged in research and development which ultimately led to the development of a process for smelting magnesium, from which process petitioner realized abnormal income. Held, in 1943 petitioner realized abnormal income from contracts as a result of research and development within the meaning of section 721(a)(2)(C) of the Internal Revenue Code.

2. The amount of net abnormal income received in 1943 attributable to the years 1936 through 1943 determined and the formula for allocation also determined. Richard S. Cole, Esq., and A. J. Beran, C.P.A., for the petitioner. John A. Newton, Esq., for the respondent.

This proceeding involves a claim for relief from excess profits tax for the calendar year 1943 in the amount of $55,502.93. Petitioner's application for relief was rejected by respondent in a notice dated June 8, 1948, which reads, in part, as follows:

It is held that you are not entitled to exclude any alleged abnormal income from your excess profits net income for 1943 under the provisions of section 721 of the Internal Revenue Code. Your claim for refund of excess profits tax has, therefore, been disallowed and notice of such disallowance is hereby given in accordance with the provisions of section 732 of the Internal Revenue Code.

Petitioner's original claim for refund was based on its claim of the receipt of net abnormal income in 1943 of $165,400.69. Petitioner now concedes that in 1943 its net abnormal income was only $110,205.26.

The sole issue is whether petitioner, in 1943, realized abnormal income within the meaning of section 721(a)(2)(C) of the Internal Revenue Code from the development of a process of smelting magnesium, part of which may be allocated to prior years under section 721(b) of the Internal Revenue Code.

FINDINGS OF FACT.

The facts stipulated are so found.

Petitioner is a corporation, duly organized and existing under the laws of Ohio. Petitioner specializes in the engineering, design, and construction of glass plants and allied equipment.

The claimed net abnormal income is income from three contracts, Nos. 1895, 1963, and 1968, with the Ford Motor Co. (sometimes referred to herein as Ford) for the construction of furnaces designed and developed by petitioner. These furnaces were used in smelting magnesium and consisted of an iron retort submerged in a bath of molten silicate.

In 1936 petitioner was contacted by the Crown Cork & Seal Co., of Baltimore, Maryland (hereinafter called Crown), relative to a new glass plant which that company proposed to have constructed. The new plant was to have an electric melting furnace for glass, a type of furnace which petitioner's engineers had heard of but with which they had never had personal contact. Petitioner was retained by Crown because of its background in designing equipment for the glass industry and because of certain patents which it owned. The actual electrical portion of the furnace was divorced from petitioner's work and was at first shrouded with a veil of secrecy. The electric melting process was developed in Sweden by Y. B. Cornelius, an engineer. His son, also an engineer, came to this country in order to exploit the process and it was from him that Crown obtained a license to employ the electric melting process.

Electric melting of glass is performed by placing in a basin a compound which it is desired to make into glass. There is then immersed in that basin two iron bars which are set in opposite ends of the basin. The compound is then heated until it reaches a molten state. Then electricity is introduced into the iron bars, which act as electrodes. The molten compound will act as a conductor of the electricity and at the same time act as a resistor to the electricity. The resistance of the compound causes it to heat and thereby the heating of the compound is carried forward. It is important that the current density be at a proper level in using the process; if the current is too high the iron electrode will melt rather than the glass. In an electric melting furnace the glass solution is hottest at the bottom which is the reverse of what occurs in a fuel-fired furnace, where it is hottest at the top. The coolness at the top in an electric melting furnace causes the solution to be viscous at that point. This prevents the freeing of small bubbles created in the solution and it results in imperfections in the finished glass.

Petitioner had developed a system of firing natural gas known as the ‘luminous flame‘ method, which had properties for heating the surface of the glass solution. This was the piece of equipment which Crown was particularly interested in obtaining from the petitioner, because it enabled the surface of the melted glass to be free from bubbles. Petitioner usually charged a fee for the use of its luminous flame burner. It did not, however, charge Crown for its use, because petitioner thought that electric melting was particularly adapted to equipment which it had and if it would be so adapted the petitioner would become closely associated with this new method of melting glass. Previous to the application of electric melting by Crown, the process had been a hand operation. It has never been completely automatic.

Officers of the petitioner had previously visited an electric melting furnace installed by Cornelius at the plant of the American Cyanimide at Niagara Falls. This plant there produced sodium silicate and petitioner was able to apply the knowledge gained there in the Crown operation. Petitioner's engineers had found that electric melting was performed at Niagara Falls without deleterious effect on the iron electrodes, because the sulphur was taken from the solution used. Petitioner had also observed that the ‘single phase‘ operation used at Niagara Falls was better than the ‘three phase‘ operation which had been used in the Crown operation. Petitioner also learned something of current density, which is the ability of an electrode to carry a certain amount of current for a unit of area, as a result of studies at Niagara Falls.

In 1935 and 1936 petitioner caused a search to be made in the public library of Toledo for material on the electric melting of glass.

The use of the process at Crown was not successful, and, after five or six weeks of attempted operation, petitioner took over to some extent the general supervision of the operation in order to find out what the difficulties might be. Ultimately the Crown operation proved a failure and that company discontinued it. After petitioner saw the results of the Crown furnace and compared it with the American Cyanimide experiment, it concluded that, while some things were radically wrong with the former, this did not condemn electric melting.

In 1936 petitioner contacted the Ford Motor Co. with the purpose of making an electric melting furnace for it. An officer of petitioner went with a representative of the Ford Motor Co. to Niagara Falls, where they met Y. R. Cornelius and then inspected the electric melting furnace of the American Cyanimide. This was the trip and study referred to in previous paragraphs, during which petitioner's engineers learned much of benefit. Following the trip to Niagara Falls, petitioner prepared several drawings and estimates of Cornelius' electric glass melting furnaces and submitted them to Ford. The offer made by petitioner to Ford Motor Co. for the construction of a Cornelius type electric furnace was made subject to the approval of Crown. The latter company was willing to have Ford construct such a furnace because it thought this would take experimental costs off its shoulders. Ford finally decided not to have the furnace constructed. Petitioner received no compensation for the expense in connection with submitting the drawings and estimates to Ford.

In 1937 petitioner was contacted by Cornelius, who had adopted his furnace to bisilicate operations. Ford was then contacted in regard to its use of a bisilicate operation. Petitioner wrote to Ford regarding the possibilities of the American Cyanamide plant in producing bisilicate, as it had been previously requested to do by that company. Ford did not act in accordance with this letter. Representatives of the petitioner made several trips to Detroit in connection with this matter, but they did not receive any compensation from either Ford or Cornelius.

During the period 1939 through 1941 petitioner worked with Cornelius in connection with projected glass plants using electric furnaces in China and Brazil and finally in Cascade Locks, Oregon. In connection with the Cascade Locks project, Cornelius prepared a report in which, under the heading ‘Technical Assistance During The Start,‘ appears the following quotation:

Glass furnaces, whether electric or combustion fired, last for a considerable time between each rebuilding, and consequently the plant engineers have little opportunity to acquire additional experience in furnace and plant construction. Most glass works, therefore, employ specialized engineering firms to do their work for rebuilding and major alterations in the plant layout. Such an expert is the Toledo Engineering Company and same has been employed to design and erect a glass plant at Cascade Locks. * * *

As a result of the time, effort, and money spent in the preliminary research and development prior to 1941, the petitioner designed an electric kiln in 1941 which embodied for the first time the practical application of the process of using the silicate bath for general heating purposes. The war intervened and this kiln was never built. No such kiln to be used for heating purposes was in existence at the time the drawing was prepared and the process of using a molten silicate bath as a heating means was not used until it was adopted in the execution of contract No. 1895.

In 1942 petitioner undertook to construct furnaces for the smelting of magnesium to be used by Ford. The furnaces were designed by petitioner to carry out specifications set forth by the Magnesium Board. The plant as originally designed by Ford consisted of about 1,000 retorts. Each retort weighed approximately 1,300 pounds and cost approximately $1,200. Some of the furnaces were completed and placed in operation in January, 1942. The method used in the furnace was known as the ‘pigeon process.‘ A furnace consisted of an alloy steel retort of pipe. A magnesium compound was placed in the retort, the retort was then subjected to the direct heat of a flame of approximately 2300 degrees Fahrenheit, and this caused the magnesium to be freed from the compound. The alloy steel retorts lasted approximately 45 days, after which they were a complete loss. The loss was due to the heat to which they were subjected and the manner that they were suspended. Alloy steel was difficult to obtain during the war, and for this reason and because of the high cost of the retorts their use in the magnesium smelters was unsatisfactory. Ford and others conducted experiments to rectify this condition. They tried to coat the retort and to rib it so that it would not collapse; none of these experiments were successful.

While these experiments were going on the petitioner submitted its own idea of a furnace which it believed would remedy the situation. When petitioner submitted its idea Ford tested it for about a week in its Dearborn laboratory and then authorized petitioner to build a pilot type furnace. Ford, in a letter dated August 10, 1942, ordered petitioner to discontinue further construction on the old type furnaces. Petitioner immediately proceeded to design and build a pilot furnace using the ideas it had submitted before. The pilot furnace was a regular commercial size unit, which was built on the partially completed foundation of one of the old type furnaces. This furnace consists of an iron retort which is immersed in molten silicate. The silicate, in turn, is held in a rectangular basin. The silicate is heated by flame and it in turn heats the retort. The silicate has a buoyant effect on the retort, which helps to support it, and the silicate bath prevents the retort from oxidizing and thus from deteriorating.

The purpose of submerging electrodes in the Cornelius electric melting process was to form an electric circuit and thus introduce electricity into the silicate bath, causing it to heat through the resistance of the molten silicate to the electricity. The purpose of submerging the retort in silicate was to provide a uniform means of heating and for support of the retort, thus keeping the tube free from oxidation. It had been learned previously, by weighing electrodes used in Cornelius furnaces, that they did not deteriorate after being submerged in silicate baths for periods of two or three years. This was the knowledge that petitioner's engineers had learned previously from contact with the Cornelius furnace and which was applied to the iron retorts.

After the pilot furnace had proved its effectiveness, the petitioner entered into the contracts involved in the instant case. Contract No. 1895, which provided for the construction of four silicate type magnesium smelting furnaces, recited in its introductory paragraph as follows:

THIS CONTRACT entered into this 5th day of November 1942, by and between FORD MOTOR COMPANY, a Delaware Corporation, of Dearborn, Michigan (sometimes herein called ‘Agent‘), acting for and on behalf of Defense Plant Corporation, a corporation created by Reconstruction Finance Corporation pursuant to Section 5d of the Reconstruction Finance Corporation Act, as amended, to aid the Government of the United States in the National Defense Program (herein called ‘Owner‘), and TOLEDO ENGINEERING COMPANY, INC. of TOLEDO, OHIO (herein called ‘Contractor‘).

In article 3 of contract No. 1895 it is recited that the ‘Owner‘ may at any time make changes in specifications. In article 5 the ‘Owner‘ was given the right to terminate the contract at any time through cause.

Contract No. 1963 was also entered into between the petitioner and the Defense Plant Corporation. It was a contract for $2,350 and was to move refractories and material to a more suitable place in the Magnesium Smelter Building. It recited as its purpose:

The Contractor shall furnish the Labor and perform the work to move refractories and material now stored in the Owner's Magnesium Smelter Building in Rows C & D to clear the site for the installation of Silicate Type furnaces to a place in the building suitable to the Owner.

Contract No. 1968 was a contract for $9,190.24 and was to cover dismantling of furnace foundations in the Magnesium Smelter Building. It provided, among other things, that:

The Contractor shall furnish the materials and perform the work for Dismantling Furnace Foundations Nos. 13 to 24 inclusive, * * * in Magnesium Smelter Building * * * .

The following stipulation shows income and direct expenses of contracts Nos. 1895, 1963, and 1968, involved in this case:

+----------------------------------------------------------------+ ¦ ¦Contract No.¦Contract No.¦Contract No.¦ +-------------------------+------------+------------+------------¦ ¦ ¦1895 ¦1963 ¦1968 ¦ +-------------------------+------------+------------+------------¦ ¦Gross contract price ¦$553,658.33 ¦$2,350.00 ¦$10,109.98 ¦ +-------------------------+------------+------------+------------¦ ¦Cost of contract: ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------¦ ¦Materials and supplies ¦276,092.30 ¦ ¦ ¦ +-------------------------+------------+------------+------------¦ ¦Labor ¦81,507.79 ¦$1,431.88 ¦$5,867.05 ¦ +-------------------------+------------+------------+------------¦ ¦Total ¦357,600.09 ¦1,431.88 ¦5,867.05 ¦ +-------------------------+------------+------------+------------¦ ¦Gross income ¦196,058.24 ¦918.12 ¦4,242.93 ¦ +-------------------------+------------+------------+------------¦ ¦Direct expenses: ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------¦ ¦Engineering salaries ¦9,452.76 ¦151.01 ¦158.10 ¦ +-------------------------+------------+------------+------------¦ ¦Employees' profit sharing¦9,371.54 ¦165.56 ¦674.75 ¦ +-------------------------+------------+------------+------------¦ ¦Traveling expenses ¦4,367.81 ¦18.60 ¦79.87 ¦ +-------------------------+------------+------------+------------¦ ¦Insurance ¦5,501.63 ¦92.94 ¦378.83 ¦ +-------------------------+------------+------------+------------¦ ¦Taxes ¦2,966.74 ¦49.85 ¦203.23 ¦ +-------------------------+------------+------------+------------¦ ¦Blueprints ¦556.56 ¦ ¦ ¦ +-------------------------+------------+------------+------------¦ ¦Depreciation ¦1,596.24 ¦6.35 ¦26.23 ¦ +-------------------------+------------+------------+------------¦ ¦Total ¦33,813.28 ¦484.31 ¦1,521.01 ¦ +-------------------------+------------+------------+------------¦ ¦Net income ¦162,244.96 ¦433.81 ¦2,721.92 ¦ +---------------------------------------------------+------------¦ ¦ ¦433.81 ¦ +---------------------------------------------------+------------¦ ¦ ¦ ¦ ¦162,244.96 ¦ +-------------------------+------------+------------+------------¦ ¦Total net income ¦ ¦ ¦165,400.69 ¦ +----------------------------------------------------------------+

One hundred twenty-five thousand dollars of the profit derived by petitioner from contracts and subcontracts subject to renegotiation under the Renegotiation Act represented the amount of the profits received or accrued under such contracts and subcontracts during the fiscal year ended December 31, 1943, which was eliminated.

The total contract price of all renegotiable contracts, including those involved herein was $1,282,077.27. The amount of renegotiation applicable to contract No. 1895 is $53,980.60 ($125,000 X $553,658.22 over $1,282,077.27). The amount of renegotiation applicable to contract No. 1963 is $229.13 ($125,000 X $2,350.00 over $1,282,077.27). The amount of renegotiation applicable to contract No. 1869 is $985.70 ($125,000 X $10,109.98 over $1,282,077.27).

The net abnormal income for contract No. 1895 is $108,264.36 ($162,244.96 minus $53,980.60). The net abnormal income from contract No. 1963 is $204.68 ($433.81 minus $229.13). The net abnormal income from contract No. 1968 is $1,736.22 ($2,721.92 minus $985.70). The total net abnormal income from all three contracts if $110,205.26.

No income or compensation of any kind was received by the taxpayer for the time and money expended by it in research, consultations, and engineering services in this development, except the income received by it in 1943 and herein claimed to be abnormal income.

The new process has other uses and has actually been put to use since the Ford contract in the production of beryllium and butadiene. The petitioner designed a glass bath heater, adapting this new process to refinery practice which was successfully operated by the Standard Oil Co.

There was no increase in the sales force of petitioner from 1935 to 1948, nor was there any increase in executive personnel. Petitioner has enjoyed the patronage of the Ford Motor Co. as a customer since 1917 and no increased sales activity was necessary to obtain contracts Nos. 1895, 1963, and 1968, since Ford was already a customer. Advertising of petitioner has been constant, a certain stated amount being deemed proper in the field of the glass industry, and no more.

The primary output of magnesium in the United States during the years 1940 to 1946, inclusive, in thousands of short tons was as follows:

+------------------------------------+ ¦1940¦1941¦1942¦1943 ¦1944 ¦1945¦1946¦ +----+----+----+-----+-----+----+----¦ ¦6.3 ¦16.3¦49.0¦183.6¦157.1¦32.8¦5.3 ¦ +------------------------------------+

The following table was submitted by petitioner for the purpose of allocating the amount of income attributable to other years. These figures are estimates based on records kept by the petitioner.

+------------------------------------------------------------+ ¦RECAPITULATION OF TIME AND COSTS BY YEARS ¦ +------------------------------------------------------------¦ ¦ ¦ ¦ ¦ ¦CONSULTING ¦ ¦ ¦ +-----+-----+-------+-------+-------------+---------+--------¦ ¦YEAR ¦ENGR.¦ENGR. ¦TRAVEL ¦ ¦TOTAL PER¦% ¦ +-----+-----+-------+-------+-------------+---------+--------¦ ¦ ¦HOURS¦COST ¦EXPENSE¦ ¦ ¦YEAR ¦OF TOTAL¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦ ¦ ¦ ¦ ¦DAYS¦COST ¦ ¦ ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1935 ¦30 ¦$360.00¦$190.00¦9 ¦$900.00 ¦$1,450.00¦20.21 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1936 ¦124 ¦558.00 ¦401.00 ¦19 ¦1,900.00¦2,859.00 ¦39.86 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1937 ¦15 ¦67.50 ¦14.00 ¦4 ¦400.00 ¦481.50 ¦6.71 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1939 ¦5 ¦22.50 ¦ ¦ ¦ ¦22.50 ¦.31 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1940 ¦16 ¦72.00 ¦ ¦1 ¦100.00 ¦172.00 ¦2.40 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1941 ¦120 ¦540.00 ¦ ¦ ¦ ¦540.00 ¦7.52 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1942 ¦120 ¦540.00 ¦48.00 ¦4 ¦400.00 ¦988.00 ¦13.77 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦1943 ¦ ¦ ¦62.00 ¦6 ¦600.00 ¦662.00 ¦9.22 ¦ +-----+-----+-------+-------+----+--------+---------+--------¦ ¦TOTAL¦ ¦ ¦ ¦ ¦ ¦7,175.00 ¦100.00 ¦ +------------------------------------------------------------+

The entire amount expended in 1935 must be eliminated and one-half of the amount expended in 1936 must be eliminated, because we fail to find that it represented money spent by petitioner in original research and development of its process for constructing magnesium furnaces. Therefore, we find from the evidence that the amounts of research and development costs of the process attributable to the various years are as follows:

+--+ ¦¦¦¦ +--+

Year Total Per cent of total 1936 $1,429.50 33.279 1937 481.50 11.210 1939 22.50 .524 1940 172.00 4.004 1941 540.00 12.571 1942 988.00 23.001 1943 662.00 15.411 Total 4,295.50 100.000

OPINION.

BLACK, Judge:

The sole issue in this proceeding is whether petitioner is entitled to relief under the provisions of section 721 of the Internal Revenue Code, the pertinent portions of which are printed in the margin.

SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.(a) DEFINITIONS.— For the purposes 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, or, if the taxpayer was not in existence for 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.

Petitioner contends that during the year 1943 it had net abnormal income of $110,205.26 of a special class from the construction of four new silicate bath type magnesium smelter furnaces and from two small moving and dismantling contracts connected therewith, which represents income from research and development of a process extending over a period of more than 12 months. Petitioner also contends that this net abnormal income is attributable to the years 1935 to 1943, inclusive, by reason of the expenses incurred in research and development of this process.

The respondent contends that the income received by petitioner from the contracts in question does not come within the class set forth in section 721(a)(2)(C) because (1) the research resulting in the development of the magnesium smelters did not extend over a period of more than 12 months, and (2) the petitioner has not demonstrated what portion of the income is the result of the use of the process and what portion is the result of other factors, such as manufacturing and installing the smelters.

Beginning in 1936, petitioner was actively engaged in original research, which ultimately led to the development of the process for smelting magnesium, as a result of which petitioner realized income which was abnormal in class within the meaning of section 721(a)(2)(C) of the Internal Revenue Code. As early as 1941 petitioner designed an electric kiln which embodied for the first time the practical application of the process of using the silicate bath for general heating purposes. This was a result of the time, effort, and money spent in the preliminary research prior to 1941. The early research of petitioner represents the first steps in the development of the process of smelting magnesium by means of a molten silicate bath.

Respondent's contention that petitioner's research did not extend over a period of more than 12 months can not stand because the evidence shows that the process from which petitioner received income in 1943 relates back to research begun in 1936.

We have found that petitioner realized net abnormal income in the amount of $110,205.26 during the year 1943. However, petitioner's right to relief under section 721 is also dependent upon its ability to show that such net abnormal income is attributable to other years and to what extent. W. B. Knight Machinery Co., 6 T.C. 519; Geyer, Cornell & Newell, Inc., 6 T.C. 96.

Section 35.721-3 of respondent's Regulations 112 which deals with this question provides, in part, as printed in the margin. As has already been stated, it is respondent's contention that none of the net abnormal income can be attributed to other years because ‘the petitioner has not demonstrated what portion of the income is the result of the use of the process and what portion is the result of other factors such as manufacturing and installing the smelters.‘ In making this contention the Commissioner seems to rely on that part of his regulations printed in the margin which reads:

SEC. 35.721-3 AMOUNT ATTRIBUTABLE TO OTHER YEARS.— The mere fact that an item includible in gross income is of a class abnormal either in kind or in amount does not result in the exclusion of any part of such item from excess profits net income. It is necessary that the item be found attributable under these regulations in whole or in part to other taxable years. Only that portion of the item which is found to be attributable to other years may be excluded from the gross income of the taxpayer for the year for which the excess profits tax is being computed.Items of net abnormal income are to be attributed to other years in the light of the events in which such items had their origin, and only in such amounts as are reasonable in the light of such events. To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer, such items shall not be attributed to other taxable years. Thus no portion of an item is to be attributed to other years if such item is of a class of income which is in excess of 125 percent of the average income of the same class for the four previous taxable years solely because of an improvement in business conditions. In attributing items of net abnormal income to other years, particular attention must be paid to changes in those years in the factors which determined the amount of such income, such as changes in prices, amount of production, and demand for the product. * * *

* * * To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for or decreased competition in the type of products sold by the taxpayer, such items shall not be attributed to other taxable years. * * *

Petitioner argues, and correctly so we think, that the $55,195.43 renegotiation settlement with the Government out of the profits received from these three contracts takes care of the factor of high prices which is mentioned in the foregoing quoted regulation. Petitioner deducted this $55,195.43 from the $165,400.69 total net income derived from the three contracts here in question in arriving at the net abnormal income which it claims should be attributed to the years of research and development. This, we think, adequately takes care of the factor of high prices. This leaves $110,205.26 net abnormal income which petitioner contends should be attributed to the years including the taxable year 1943, when research and development expenses took place.

The petitioner next argues that the factor of low operating costs as mentioned in the regulations is not present in the instant case because the facts show that the operating costs connected with the performance of these contracts were normal for the year in which they were performed and that there was not present any factor of low operating costs. We think that the evidence establishes this to be true, and we so hold.

Petitioner next contends that, under the facts which we have in the instant case, the clause of the regulations which speaks of the effect to be given to the factors of ‘increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer‘ is not applicable here. Petitioner submits that it is not engaged in a manufacturing business; that it sells services to its customers; that what it did in the taxable year under the main contract was to construct four magnesium smelting furnaces for the Ford Motor Co. and that the other two contracts were dismantling contracts incident thereto; and that the ‘improvement in business conditions‘ clause of the regulations is not applicable.

Respondent, on his part, argues in his brief that:

* * * The idea of submerging an iron retort in silicate was used as the basis for the construction of the furnaces but in their design and construction, petitioner undoubtedly employed draftsmen, engineers, laborers, etc. The service performed by these persons was a thing of value and a portion of the income from the furnaces should have been compensation for it. To the extent that the income is the result of these factors, it is not abnormal income within the meaning of section 721(a)(2)(C). Ramsey Accessories Manufacturing Corporation, supra. * * *

It seems to us that, under the facts of the instant case, Ramsey Accessories Manufacturing Corporation, 10 T.C. 482, which was, as its name implies, a manufacturing corporation, is not applicable. Here, the petitioner did not increase its plant facilities, it had no plant; it did not increase its capacity, because it was not in the manufacturing business; it did not acquire a new customer, it had serviced Ford since 1917; and it did not increase its sales force, for the sales contracts were made by the three owners of the petitioner, who had always acted in that capacity. Petitioner did not use another's patents; on the contrary, it was able to earn the $110,205.26 in question because it had at last been able to commercialize on a process which it had developed over a period of several years and which reached its fruition in the taxable year 1943 and was largely due to the personal services and ability of its engineers. These same three men were its officers and stockholders and the directing force of the business. For these reasons we do not think any part of the $110,205.26 in question should be excluded as not resulting from the research and development of the process, on account of the factors used in Ramsey Accessories Manufacturing Corporation, supra. On the contrary, we think this $110,205.26 should be attributed to the years 1936 to 1943, inclusive, in proportion to the percentages set out in our findings of fact.

Respondent contends that petitioner's method of allocation of net abnormal income to other years is highly inaccurate. It is true that accurate records on expenditures were not kept during the time of petitioner's research and development, but, as we said in Rochester Button Co., 7 T.C. 529, ‘a taxpayer's books are not kept with prophetic vision as to the future requirements of income tax legislation.‘

We have eliminated from petitioner's estimate all of the money expended in 1935 and one-half of the amount expended in 1936, which sums were for the acquisition of existing knowledge concerning electric melting and, therefore, in our view, can not be considered as having been expended for research and development of magnesium smelting furnaces within the meaning of section 721(a)(2)(C) of the Internal Revenue Code and section 35.721-7 of respondent's Regulations 112.

SEC. 35-721-7 EXPLORATION, DISCOVERY, PROSPECTING, RESEARCH, OR DEVELOPMENT.— The second class of potentially abnormal income specifically set forth in section 721(a)(2) is income resulting from exploration, discovery, prospecting, research, or development of tangible property (such as mines, oil producing property, and timber tracts), patents, formulae, or processes, or any combination thereof, extending over a period of more than 12 months. The exploration, discovery, prospecting, research, or development must be that of the taxpayer. Income resulting from activities of such a character carried on by a predecessor is not entitled to the treatment provided in section 721.

After eliminating the claimed expenditures which, we think, are not within the intendment of the statute, we have found petitioner's allocation of expenditures to be reasonable and proper, although they were necessarily based on estimates. Cf. Keystone Brass Works, 12 T.C. 618.

Reviewed by Special Division.

Decision will be entered under Rule 50.