*70 Decision will be entered for the respondent.
Petitioner having worked for less than 12 months on a program of development initiated several years earlier by another corporation from which petitioner indirectly acquired its assets, held not entitled to relief under section 721 (a) (2) (C), Internal Revenue Code, requiring research or development "extending over a period of more than 12 months."
*489 By this proceeding petitioner challenges a deficiency in excess profits tax of $ 39,835.04 for the year 1942. The only question is whether and *490 to what extent petitioner is entitled to relief from excess *71 profits tax under Internal Revenue Code, section 721 (a) (2) (C). Other adjustments are not contested.
FINDINGS OF FACT.
Petitioner, a New Jersey corporation, filed its excess profits tax return for 1942 with the collector of internal revenue for the fifth district of New Jersey.
Electronic Mechanics, Inc., a New York corporation, hereinafter called the New York company, was organized on September 20, 1935. It was engaged in manufacturing and machining insulating materials composed of mica and glass. At that time the principal producer of similar materials was the Mycalex Corporation in England, hereinafter called English Mycalex, which had a subsidiary in this country called Mycalex Corporation of America, hereinafter called American Mycalex. The product manufactured by both English and American Mycalex was known as Mycalex.
The New York company's founder, president and chief engineer, was Delbert E. Replogle. Educated as an electrical engineer, from 1920 to 1935 he was associated in engineering and executive capacities with various manufacturers of electrical and electronic products, including Edison Electric, Raytheon Co. (manufacturer of a rectifier for radios), Jenkins Television*72 Corporation, De Forest Radio Corporation, and Hi-Grade Sylvania Corporation. Communications Products Corporation, which he formed but never incorporated, in 1935 transferred its assets in exchange for stock in the New York company.
In about 1933, while employed as chief engineer of De Forest, Replogle secured several thousand pounds of Mycalex from American Mycalex for insulation in radio transmitters. At that time and under Replogle's supervision, De Forest began to attempt methods of machining the Mycalex with reduced breakage. Replogle continued his work on Mycalex in 1934 as vice president in charge of production at Hi-Grade Sylvania's transmitting tube plant. He organized Communications Products Corporation with a view to carrying on the same process.
The New York company imported Mycalex from English Mycalex in sheets ranging from one-eighth inch to one inch in thickness. The material was in general practice and in accordance with instructions from English Mycalex cut with steel band or cut-off saws, drilled with steel drills and turned in a lathe with regular steel bits. Each of the operations resulted in a high percentage of breakage and chipping.
To develop more satisfactory*73 methods for cutting, the New York company, during the period 1935 to 1940, experimented by using *491 ceramic wheels of varied grits and grades in conjunction with a water lubricant. The method finally established eliminated chipping, facilitated straight cuts through long, heavy sheets, and resulted in more polished edges which absorbed less moisture.
A similar process of experimentation in methods of drilling Mycalex was carried out during the same period. To avoid chipping, the New York company tried using box jigs and drilling from one piece of material into another. Both methods brought partially satisfactory results but were expensive. Finally the "hardened block" method was devised in which the material was drilled with tungsten carbide drills in one direction until the drill point touched a metal block underneath and then was turned over and drilled from the reverse side. This method required a lubricant, and the best one for the purpose was found experimentally to be water mixed with a soluble oil.
By using the same grade of ceramic wheel as found satisfactory for cutting, the New York company was able to slot a Mycalex bar with reduced shrinkage. As slotted in*74 the conventional manner on a milling machine, shrinkage was more than 75 per cent. As its orders often required the grinding of Mycalex sheets to specified thicknesses, the New York company built several experimental surface grinders, and in 1940 purchased a heavy grinder. It was reworked to surface grind the sheets satisfactorily at a cost of 10 cents a sheet, as compared to the cost of $ 2.50 a sheet incurred by use of grinding methods in common practice.
Throughout the years 1935 to 1940, while engaged in developing the methods described above, the New York company had the further problems of the water lubricant rusting its equipment, and the grains of material obstructing the saw or lathe. To overcome these difficulties substantial retooling of machinery was undertaken.
As an insulating material Mycalex had very good electrical characteristics, but its surface resistivity was low when wet. Numerous complaints of this deficiency were received by the New York company from Westinghouse, Radio Corporation of America, Federal Telegraph, and Western Electric. Even after satisfactory machining methods were devised, the use of Mycalex was principally confined to insulation of radio*75 transmitting equipment. Beginning in 1935, shortly after its incorporation and continuing throughout the same period as that during which new cutting and machining methods were being tried, the New York company experimented in producing a mica and glass insulator superior to Mycalex. Specifically, Replogle wanted to produce a stronger material with a higher surface resistivity which could be machined at reduced breakage loss. Glass powders called "Frits" were obtained from American Mycalex and mixed with mica. The New York company had access to and used the information *492 disclosed in patents of English Mycalex. In addition, Replogle was familiar with two Crosley patents and one Wedlock patent.
By mixing very finely divided mica with the "Frits" under high pressure, the New York company made a material stronger and of higher polish than Mycalex. A method was devised for cold-pressing the mixture of "Frits" and mica which was less expensive than a process previously used. After pressing, the material was heated. Tests were made with various types of heat in order to secure uniform results. An electric oven was purchased but failed to give satisfaction and finally a *76 gas oven was used. The exact temperature for heating and pressing, the type of steel from which the mold was constructed, and the type of lubricant best suited to keep the mold at high temperature were the subjects of numerous experiments. Huron steel and palm oil or graphite-laden mineral oils were finally selected. Methods of transferring the heated sheet from oven to mold without destruction were also matters of experiment.
A further problem concerned the forming of pieces so that they would be directly usable without the necessity of cutting and shaping. A process was established after numerous tests consisting of heating the material, and while in a plastic state pressing it in a mold into the desired shape.
Early in 1938 it became apparent that the New York company required expanded working quarters. At that time a building was acquired in Paterson, New Jersey, and the equipment was moved to it from New York. No qualifying certificate to transact business in New Jersey was ever filed by the New York company. Eighty-seven of its 100 outstanding shares of stock were held by Replogle's wife for his benefit, and the remaining 13 shares by Wendell Kershner. The officers were: *77 Replogle, president; Kershner, treasurer; and Grace L. DuVall, secretary.
The New York company continued to operate in New Jersey, using the same books and records. In 1940 the officers became aware of their failure to comply with New Jersey law by filing a proper certificate, and by a certificate of dissolution executed on February 16, 1940, the New York company was formally dissolved. The certificate of dissolution was filed with the Department of State of New York on April 1, 1940.
Petitioner was incorporated in New Jersey on September 3, 1940. It retained the same stock ledger book as used by the New York company, but maintained a different minute book and stock certificate book. No new investments were made in the business. Both the shareholders and officers were the same. In its returns on Form 1120 for 1940, 1941, and 1942, petitioner identified itself as a New York corporation incorporated on September 16, 1935. The "Kind of Business" was reported as "Machine Shop" on the return for 1940 and as *493 "Manufacturer of Tools and Mica Products" on the returns for 1941 and 1942.
Petitioner continued the experiments begun by the New York company, and by the end of 1940*78 experimentation was completed and both its new insulating material and machining methods had been developed and were ready for the market.
Petitioner's new insulating material was called Mycalite until 1942 or 1943, when the name was changed to Mykroy. Unlike Mycalex it met governmental specifications for grade "G" insulation as required in many contracts. It was the first insulating material to meet the "L-4" classification established in 1944. Petitioner's material was never patented because petitioner felt that the secrecy of its operations was more important than disclosure of them in patent applications.
The profit and loss statements of the New York company for 1936 to 1939, inclusive, and of petitioner for 1940, disclose the following:
| Year | Net loss |
| 1935 | $ 22.43 |
| 1936 | 93.43 |
| 1937 | 229.17 |
| 1938 | 16.58 |
| 1939 | 3,351.68 |
| 1940 | 152.20 |
"Engineering expenses" in the same years, being the aggregate amounts paid in each year to Replogle and Frank DuVall for engineering services appeared on the books as entries in the "sales expenses and commissions" account, as follows:
| Year | Amount |
| 1935 | $ 1,018.94 |
| 1936 | 4,514.41 |
| 1937 | 4,360.05 |
| 1938 | 1,999.85 |
| 1939 | 2,734.80 |
| 1940 | 2,067.03 |
*79 Amounts entered on the books as expenses of "Experimentation" were as follows:
| Year | Amount |
| 1936 | $ 173.35 |
| 1937 | 620.65 |
| 1938 | 299.00 |
| 1939 | 818.54 |
| 1940 | 929.83 |
Petitioner's profit and loss statements for 1941 and 1942 disclose the following:
| Year | Net sales | Net income |
| 1941 | $ 259,415.17 | $ 62,495.49 |
| 1942 | 816,398.74 | 54,905.94 |
In its income and declared value excess profits tax return for 1942 petitioner reported that its gross sales of $ 909,466.57 were all billed during that year under "government contracts or sub-contracts." One use to which insulating materials were put during the war was in fabrication of radar equipment. The war naturally was responsible for much of the rapid growth that occurred since 1938. The skyrocketing of Mykroy production was inevitable. The needs of the Armed Forces were met. Mykroy was produced in sufficient quantities, in fact, to make possible the announcement that no shortage of *494 Mykroy existed. As disclosed in its returns for 1940 and 1941 petitioner was engaged in those years in the "production of facilities for national defense through Government contracts or sub-contracts." For 1941 and 1942 petitioner had a "Certificate*80 of Necessity" covering its equipment, and as disclosed in its return for 1942, it acquired machinery and equipment at a cost of $ 58,409.50 and $ 48,681.90 in 1941 and 1942, respectively. Funds for purchasing the equipment were obtained by a loan from the Defense Plant Corporation in 1941.
Petitioner had loss years in both 1945 and 1946.
In its excess profits tax return for 1942 petitioner claimed relief under section 721, Internal Revenue Code. It computed a 1942 "Abnormal Income" of $ 86,639.87, being 10 per cent of the year's net sales. The following explanation was given:
ABNORMALITY OF INCOME. -- Almost all of the taxpayer's net income for 1942 -- $ 111,724.42 -- was due to the experimentation, research and development made by it in the years 1936 through 1940. Had it started such manufacture in 1942, without the benefit of the formulae, etc., thus perfected, its net sales would have been about the same as they were in 1936 ($ 34,867.70), instead of $ 866,398.74 which they were in fact; and its net operation a loss, instead of the net profit of $ 111,724.42. Or, assuming it commenced manufacture in 1942, employing similar formulae, processes, machinery and data developed*81 by a stranger, it would of course be required to pay a license fee or royalty to the developer. Considering the difficulties and length of the development, the great skill and technical knowledge involved, the intricate special equipment which had to be designed for such specialized work, and the economic value of the finished product, a reasonable license fee or royalty is 10% of the net sales. This would involve an allocation of $ 86,639.87 (10% of the $ 866,398.74) for such license fees or royalties, and leave $ 24,915.45 as net profit for the year, a reasonable amount for this corporation in view of its capital stock of $ 37,138.06 and the nature of its business. The sum of $ 86,639.87 is therefore taken as the Abnormal Income of the taxpayer for 1942.
Petitioner's Net Abnormal Income" for 1942, according to the return, was $ 72,947.12, computed as follows:
| Abnormal income | $ 86,639.87 | |
| Net income | ||
| 1941 | $ 50,487.13 | |
| 1940 | 152.20 | |
| 1939 | 3,367.08 | |
| 1938 | 49.94 | |
| Total | $ 47,016.79 | |
| Average | 11,754.20 | |
| 125 per cent of average | 14,692.75 | |
| Net Abnormal Income | $ 72,947.12 |
"The Net Abnormal Income" of $ 72,947.12 was allocated in the*82 return equally among the years 1936 to 1940, inclusive.
Petitioner now claims "Abnormal Income" and "Net Abnormal Income" for 1942 of $ 167,288.46 and $ 40,443.04, respectively.
*495 Petitioner seeks to allocate its claimed "Net Abnormal Income" of $ 40,443.04 among the years 1935 to 1940, inclusive, in the proportion that each year's "development expenses" as recorded on the books of account bear to the total "development expenses."
"Engineering expenses," being the amounts paid to Replogle and DuVall for engineering services as described above, were included by petitioner in its claim as "development expenses."
In his notice of deficiency respondent "determined that you are not entitled to relief under section 721 of the Internal Revenue Code for the taxable year 1942."
OPINION.
We are met at the threshold by a question said to be of first impression: Whether petitioner, not having existed for 12 months, could possibly avail itself of the relief accorded by section 721 (a) (2) (C) for research and development "extending over a period of more than 12 months." 1 Respondent's regulations expressly require that the research and development "must be that of the taxpayer." 2*84 Petitioner*83 attacks the regulation as being arbitrary and invalid. We find it, however, to be firmly buttressed upon the legislative history. 3 For that reason if for no other, we view it as applicable here. The New York corporation to whose property petitioner succeeded may not have been its "predecessor" although to us that appears the most apt description of their relationship. See, e. g., Lorillard Co. v. Peper, 65 Fed. 597, 598. *496 But, if not, it was still a separate corporation and if the research and development was carried on by it, it could not have been the activity of petitioner.
Nor can we agree that petitioner existed de facto, although not de jure, prior to its formal incorporation. Not only was the business carried on for several years *85 -- though without the necessary qualifying certificate -- by and under the name of the New York corporation, and not by any purported New Jersey organization, but there is no adequate showing that between the dissolution of the New York corporation and the organization of petitioner the individuals who conducted the business attempted in any respect to be carrying on a corporate venture. The necessary prerequisites for treatment as a de facto corporation under New Jersey law hence fail to appear from this record. 4 And this is not a case of the merger of two corporations of whose existence it can be said there is thus an uninterrupted continuation. Cf. Stanton Brewery, Inc. v. Commissioner (CA-2), 176 Fed. (2d) 573, reversing 11 T. C. 310. We conclude that petitioner did not engage in research and development for a period of more than 12 months, and hence that it could under no circumstances be entitled to relief under section 721 (a) (2) (C).
*86 Decision will be entered for the respondent.
Footnotes
1. SEC. 721. * * *
(a) Definitions. -- For the purposes of this section --
* * * *
(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; or
* * * *↩
2. 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↩.
3. "Section 721 (a) of the Senate amendment was designed to provide relief in the case of * * * (3) Income resulting from the exploration, discovery, prospecting, research, or development of tangible property, patents, formulas, or processes, or any combination thereof, by the taxpayer or any of its predecessors, providing that such exploration, etc., extended over a period of more than one year; * * * the conference agreement retains section 721 with the following modifications: (1) The item relative to income resulting from explorations, etc., has been rewritten. The exploration, etc., from which the income is derived must be the taxpayer's own exploration. Income resulting from activities of such a character carried on by a predecessor corporation is not entitled to the treatment provided in section 721." (H. Rept. No. 3002, 76th Cong., 3rd Sess., pp. 50, 51; 1940-2 C. B. 556↩). [Emphasis added].
4. "* * * To establish the existence of a de facto corporation it must be shown: That there is a law under which a corporation with the powers assumed might be incorporated: that there has been a bona fide attempt to organize a corporation in the manner prescribed by the statute, and that there has been actual exercise of corporate powers. * * * On the other hand, where there is merely an intention existing in the minds of certain parties to form a corporation but they have not put their purpose into operation, no de facto corporation exists. Federal Advertising Corp. v. Hundertmark, 109 N. J. Law, 12, 160 A 40. * * *" ( Gallant et al. v. Fashion Piece Dye Works, 116 N. J. Eq. 483, 174 A. 248">174 A. 248, 249↩).