*287 Decision will be entered under Rule 50.
1. The petitioner, a manufacturer of brush materials, developed a new product, utilizing to a small degree waste formerly sold as such. Experimentation in the development resulted in sales during the fiscal year 1940, but continued in that year. Held, on the facts, that for purpose of computation of excess profits tax, an operating loss of the department devoted to the development of the new product was not a deduction within section 711 (b) (1) (J) (ii), Internal Revenue Code; held, further, that such loss was the consequence of change in type, manner of operation, size, and condition of petitioner's business. Restoration to base period income therefore denied.
2. Reasonable amount of compensation for personal services actually rendered by executive officer of petitioner determined on the facts.
3. Bonus to executive officer held, on the facts, not accruable in the fiscal year 1943 when voted, in an indefinite amount subject to a maximum, and contingent upon financial condition in the opinion of the treasurer, who was the executive officer involved; it not appearing that the amount was determined upon during the year or that*288 the amount was ever accrued on the corporate books.
*103 This proceeding involves deficiencies for the fiscal years ended May 31 in 1942 and 1943, as follows:
| 1942 | 1943 | |
| Income tax | $ 6,127.82 | |
| Declared value excess profits tax | 9,757.65 | $ 1,423.53 |
| Excess profits tax | 44,396.72 | 38,769.69 |
*289 The petitioner claims an overpayment of excess profits tax in 1942 and excess profits tax and declared value excess profits tax in 1943. The issues are whether the Commissioner erred in disallowing as deductions $ 72,000 in 1942 and $ 22,000 in 1943 as compensation for services of petitioner's president and treasurer; whether the additional amount of $ 50,000, authorized but not accrued in 1943, is deductible as compensation for the same officer; and whether petitioner is entitled to disallowances of "losses" under the provisions of section 711 (b) (1) (J) of the Internal Revenue Code. The stipulation of facts is by reference incorporated herein as part of our findings of fact.
FINDINGS OF FACT.
Petitioner is a Vermont corporation, organized in 1913 and having its principal place of business in Burlington, Vermont. During the taxable years it kept its books on the accrual basis and filed its tax returns with the collector at Burlington, Vermont.
The business of petitioner at all times has been that of importing and processing fibers, horse hair, and related materials and the sale thereof to manufacturers throughout the United States. During the taxable years sales were made to*290 most of the broom and brush manufacturers in the United States. At all times some of its waste material was sold to upholsterers and hair concerns. It is the successor of a business established in 1873 by E. B. and A. C. Whiting.
The petitioner imported its raw materials from Mexico, from which it obtained materials called Tampico or istle, Brazil, India, Java, Africa, Canada, and Argentina. The petitioner processed the raw materials to meet the needs of its customers. It has from 15 to 20 standard mixtures acceptable to all manufacturers and about 8,400 formulae for grades of fiber, which are used from time to time. It averages about 300 special orders from manufacturers each day. At times petitioner produces material for a specified purpose and submits samples to prospective buyers. During 1941 to 1943, inclusive, it had about 450 customers. It supplied about 80 per cent of the country's requirements of grades of materials known as Tampico or istle, tula, palmyra, and pita; about 70 per cent of bass; and about 40 per cent of horse hair. Sales of petitioner and the variety of its mixtures of crude material exceed those of any other brush fiber manufacturer *104 in the*291 United States. No other manufacturer produces a complete line of brush fibers.
Thomas A. Unsworth, who was born in 1876, has been engaged in the brush and broom fiber business since 1893 and has been with petitioner since 1913. He became president of petitioner about 1920, and during the taxable years was president, treasurer, and a director of petitioner. He had been a stockholder since incorporation of the company, originally owning half of the common stock and acquiring additional common stock in 1920.
During the taxable years Unsworth exercised general supervision over the affairs of petitioner, purchased all of the raw material used by it, made practically all of the sales of its product, and arranged for loans necessary to conduct its affairs. Obtaining raw material was one of the most valuable services performed by him for petitioner. Scarcity of labor in Mexico and lack of sufficient ocean transportation from foreign countries made it more difficult than formerly for petitioner to obtain its requirements of raw material during the taxable years. The contacts petitioner had with dealers and brokers for the purchase of raw materials were made by Unsworth. Such contacts*292 enabled petitioner to acquire raw material that other manufacturers could not purchase.
Petitioner has never employed salesmen for the express purpose of selling its products. Sales were frequently made by Unsworth as the result of solicitations made on the telephone and visits by him to the places of business of brush manufacturers. He made sales every day he was in a position to do so. At least 60 per cent of petitioner's business was done on orders received without any price specified.
Prior to and during the taxable years, Unsworth, when extra duties required it, frequently worked at the plant until 11 o'clock in the evening. Much of such additional work was performed during the period when petitioner was developing a product sold under the trade name of tulatex. He personally prepared a large number of formulae used by the petitioner and originated the formula type of operation in the industry. There is no other man in the brush fiber industry comparable to Unsworth. The bank from which petitioner borrowed money during the taxable years required Unsworth to endorse the notes given for the loans.
During the taxable years petitioner was able to sell practically all of the*293 products it had on hand, including all old and obsolete items. In October 1941 Unsworth purchased for petitioner at a competitive public auction sale conducted by a United States Marshal at Port Everglades, Florida, 110 carloads of crude istle and a quantity of resin and phosphate, paying therefor $ 60,000, which amount was $ 2,500 in excess of the highest bid of five other bidders. The amount paid for the istle was about 2 1/4 cents a pound, or 6 cents a pound under the market price *105 f. o. b. Laredo or Brownsville. The low price paid for the material enabled petitioner to make an additional profit of about $ 350,000 in the fiscal year 1942. Negotiations conducted by Unsworth with railroads for a reduction of freight rates on the material resulted in a saving of about $ 60,000 on the cost of transporting the shipment to petitioner's plant.
In September 1935 petitioner opened a separate account on its records under the name of "Hairtex Department," later called "Tulatex Department." The operation of the department became profitable during the fiscal year 1941, but the department was discontinued as of May 31, 1941, upon the transfer of the land, buildings, equipment, and*294 material used in the department, together with other buildings, to the Queen City Tulatex Corporation or to the Burlington Realty Co., corporations all of whose stock was acquired by petitioner on June 2, 1941. The land and buildings were transferred to the Burlington Co., which leased them to the Tulatex Corporation for a rental of $ 26,671.50 in the fiscal year 1942 and of $ 81,014.85 the next year.
During the fiscal year 1942 Unsworth was required to do considerable traveling to Mexico in connection with the procurement of istle. At that time Mexico prohibited the export of crude istle except under its regulations. In November 1941 Unsworth caused the organization of a corporation, known as Fibras Duras, under the laws of Mexico, to process raw istle and supply the needs of the Tulatex Corporation for curled istle for exclusive use in the production of tulatex and for sale to upholsterers and foreign users without violating export regulations of Mexico. The stock of Fibras Duras was owned by Unsworth. About 90 per cent of the tulatex produced by the Tulatex Corporation was manufactured from material acquired from Fibras Duras.
During a period of three and one-half years, commencing*295 in about February 1941, Unsworth devoted some time negotiating the cancellation of an agreement entered into by petitioner in February 1941 for the distribution and sale of tulatex. During the taxable years the negotiations were conducted on behalf of the Tulatex Corporation.
Orders issued by the War Production Board during petitioner's fiscal year 1941 or 1942 restricted the use of rubber and temporarily prevented the production of tulatex by the Tulatex Corporation. In the taxable years Unsworth attended a great many conferences with officials in Washington to obtain permission to use curled istle waste with reclaimed rubber in the production of tulatex. Such permission was granted, but restricted to war orders. During that period he also spent some time developing patents for the Tulatex Corporation, and on from five to ten occasions each year he spent from five hours to *106 two or three days visiting plants and attending other conferences with respect to tulatex.
The net earnings of petitioner, after taxes, from 1920 to the close of the fiscal year 1936 were about $ 1,620,000. During that period the corporation paid cash dividends of about $ 695,000 and stock dividends*296 in the amount of $ 640,000. Petitioner's net sales, adjusted net income after officers' salaries and bonuses, Federal income and profits taxes, and cash dividends paid for the fiscal years 1937 to 1943, inclusive, omitting cents, were as follows:
| Year | Net sales | Net income | Taxes | Dividends |
| 1937 | $ 2,496,246 | $ 271,585 | $ 40,601 | $ 326,500 |
| 1938 | 1,798,388 | 88,651 | 12,949 | 65,877 |
| 1939 | 1,728,390 | 116,341 | 19,749 | 58,002 |
| 1940 | 2,650,390 | 242,314 | 40,562 | 65,897 |
| 1941 | 3,591,002 | 458,569 | 159,981 | 80,284 |
| 1942 | 5,129,722 | 1,017,297 | 654,654 | 115,497 |
| 1943 | 5,088,379 | 511,915 | 336,059 | 82,580 |
The sales of hairtex or tulatex, included in the figures for net sales, were $ 44,323, $ 13,939, $ 19,378, $ 43,521, and $ 1,020,865 during the fiscal years 1937 to 1941, inclusive, respectively. Petitioner paid a stock dividend of $ 316,250 in the fiscal year 1937. The increase of profits in 1942 over 1941 was due, in part, to the sale of old goods at high prices, low cost of material, increased sales, and an increase in the selling price of finished products. From 10 to 15 per cent of the increased profits was due to increased selling prices. During the fiscal year 1943 the Office*297 of Price Administration rolled back the prices of petitioner's finished products without control of the cost of the raw materials imported from foreign countries.
The balance sheets of petitioner at the close of the taxable years were as follows:
| 1942 | 1943 | ||
| ASSETS | |||
| Cash | $ 325,068.00 | $ 319,382.96 | |
| Notes and accounts receivable | 534,514.73 | 427,647.55 | |
| Inventories | 697,631.84 | 698,277.86 | |
| Investments: | |||
| U. S. Treasury notes | 116,200.00 | 10,000.00 | |
| Stocks of domestic corporations: | |||
| Subsidiaries | $ 518,500.00 | ||
| Other investments | 27,291.75 | ||
| 545,791.75 | 522,076.00 | ||
| Depreciable assets less reserves | 134,452.97 | 141,969.19 | |
| Land | 12,466.40 | 12,466.40 | |
| Cash surrender value life insurance | 231,851.49 | 229,386.92 | |
| Deferred charges | 7,970.26 | 4,892.92 | |
| Total | 2,605,947.44 | 2,366,099.80 | |
| LIABILITIES | |||
| Accounts payable | 120,115.96 | 83,722.94 | |
| Accrued expenses: | |||
| Taxes * | 719,298.56 | 449,057.65 | |
| Salaries and wages | 1,806.40 | 4,029.08 | |
| Capital stock | 1,141,500.00 | 1,143,000.00 | |
| Surplus * | * 623,226.52 | * 686,290.13 | |
| Total | 2,605,947.44 | 2,366,099.80 |
*107 On May 31, 1941, *298 Unsworth owned all of petitioner's outstanding common stock, 44 shares of the 2,616 shares of outstanding 5 per cent nonvoting, A preferred stock, and 3,821 shares of the 5,807 shares of outstanding 6 per cent voting B preferred stock. Members of his family owned 1,446 shares of the B preferred stock. The B preferred stock shared in dividends equally with common stock after 7 per cent had been paid on the latter and 6 per cent on the former.
The regular annual salary of Unsworth for the fiscal years 1941 and 1942 was $ 36,000 and for 1943, $ 48,000. In addition thereto he drew the following salaries from the Tulatex Corporation and Burlington Realty Co., as the president and treasurer of each corporation for the fiscal years 1942 and 1943, during which the net income reported by the corporations was in the amounts shown:
| 1942 | 1943 | |
| Queen City Tulatex Corporation: | ||
| Salary | $ 12,000.00 | $ 8,500.00 |
| Net income of company | 113,235.86 | * 17,243.35 |
| Burlington Realty Co.: | ||
| Salary | 3,000.00 | 6,500.00 |
| Net income of company | 23,903.16 | 31,075.26 |
Unsworth received a bonus ($ 30,000) in 1941 for the first time. The income tax return of petitioner for that year*299 reported a salary of $ 36,000 paid to Unsworth for devoting all of his time to its affairs. The bonus of $ 30,000 and other bonuses paid to officers and employees were charged to cost of goods sold pursuant to the accounting practice of petitioner. For the calendar years 1942 and 1943 Unsworth reported a salary of $ 1,375 each year from the Queen City Realty Corporation. For a period of about three years, between the years 1920 and 1930, petitioner paid bonuses to salaried employees, excluding Unsworth, based on operating profits, and charged the amounts to cost of goods sold. During the fiscal year 1942 Unsworth spent about one-half and during the fiscal year 1943 about one-third of his time in Mexico or Washington. He drew no salary from Fibras Duras. In the fiscal year 1943 Unsworth spent considerable time in connection with improvement of the buildings of the Burlington Realty Co. and for that reason took a salary from it in excess of his compensation for the prior year. He spent about three months in a hospital in 1943, but kept in touch every day with officials of his plant. Petitioner, the Tulatex Corporation and the Burlington Realty Co. were regarded by Unsworth as*300 one entity. A minor part of the salary paid by petitioner to Unsworth was for services rendered to the Tulatex Corporation and Burlington Realty Co. Unsworth gave no thought to the distribution of his time among the three corporations.
*108 At a special meeting held by the directors of petitioner on February 28, 1942, the vice president informed the directors that "unusual demands" had "been made upon the president, T. A. Unsworth, in negotiating the affairs in general of the company in Mexico" and after considering the matter a resolution was adopted to pay $ 25,000 to Unsworth "as additional compensation for extraordinary services and an unsual demand upon his time and effort in negotiations in Mexico for additional supplies of crude materials." Unsworth was in Mexico at the time of the meeting.
On April 18, 1942, the directors, Unsworth being present, increased the salary of Unsworth to $ 48,000, effective as of June 1, 1941, voted him a bonus of $ 50,000 "for his services rendered during the present fiscal year," and provided that the bonus "should be paid at such time as in the discretion of the treasurer the finances of the corporation will permit." At the same meeting*301 the directors declared an extra dividend of 5 per cent on the B preferred and common stock payable "at the discretion of the Treasurer," ratified the action of the president in paying bonuses totaling $ 25,992.50 to employees the previous month, and authorized the payment of additional bonuses aggregating $ 40,667.50 to employees during that fiscal year, "at the discretion of the treasurer."
At a special meeting held on March 13, 1943, Unsworth not being present, the directors authorized the payment of $ 25,000 to Unsworth "as additional compensation for extraordinary services and an unusual demand upon his time in an effort to obtain materials restricted by government regulations; also extra effort to obtain increased production by the factory, the same being in accordance with the usual custom of the Corporation."
On May 29, 1943, the directors of petitioner declared an extra dividend of 2 per cent on B preferred and common stock payable on or before May 31, 1943, and passed a resolution:
* * * that a sum up to but not to exceed $ 50,000 be paid to Mr. Thomas A. Unsworth, President of the Corporation as additional compensation for extraordinary services and an unusual denand [*302 sic] upon his time in an effort to obtain material restricted by Government Regulation, also extra effort to obtain increased production of the factory, the same being in accordance with the usual custom of the Corporation, and that said bonus should be paid at such time as in the discretion of the Treasurer the finances of the corporation will permit.
At the same meeting authority was given for the payment of additional bonuses of $ 41,116 to employees on or before May 31, 1943.
In 1941 and 1942 petitioner paid to two of its other officers a total of $ 9,363 and $ 20,501.51, respectively, in bonuses, and in 1943 a total of $ 13,074.60 to three other officers. During the same years it paid bonuses aggregating $ 38,159.54, $ 66,775.13, and $ 47,166.95, respectively, to its employees.
The bonus of $ 50,000 granted Unsworth on May 29, 1943, was paid *109 by payments of $ 5,000 in September, $ 40,000 in November, and $ 5,000 in December 1943, and was included by Unsworth in his return for the calendar year 1943. The amount was claimed as a deduction in the return of petitioner for the fiscal year ended May 31, 1944. In its return for the fiscal year 1943, petitioner claimed*303 a deduction of $ 73,000 for salary of Unsworth.
In his determination of the deficiency for 1942 the respondent disallowed $ 72,000 of the $ 123,000 claimed as a deduction for salary of Unsworth, upon the ground that it was in the nature of a distribution of increased profits rather than reasonable remuneration for additional services. The amount claimed in 1943 in excess of $ 51,000 was determined by respondent to represent unreasonable remuneration for services actually rendered, and not allowable as a deduction.
The amount of $ 90,000 is a reasonable allowance each taxable year as compensation for personal services rendered by Thomas A. Unsworth.
In September 1935 petitioner began to conduct experiments on the use of waste fiber and surplus materials in its manufacturing operations and opened an account on its books under the name of "Hairtex Department." The name was later changed to "Tulatex Department." Prior thereto it sold the waste fiber to upholsterers. Petitioner acquired the trade-mark "Hairtex," the trade name, and some machinery from an individual. The purpose petitioner had for entering into the new venture was to realize a higher price for its waste material. From*304 September 1935 through part of its fiscal year 1939, petitioner developed, manufactured, and sold the product known as "Hairtex." The manufacture of hairtex was conducted in a warehouse known as the Baldwin Building, already owned by petitioner, and involved dyeing, crimping, and other processing of waste and inferior grades of fiber, in connection with which a very small amount of hair was used. Sales of hairtex were made by petitioner principally to upholsterers.
Petitioner found that the material was not stiff enough, and to overcome it had to use tula and tampico, which made the business unprofitable. Repeated experiments were made during the fiscal years 1935 to 1938, inclusive, with machines to improve the methods and processes of manufacture.
In June 1938 petitioner began to experiment on a product subsequently called tulatex. The product was made from lower grades of crude tula and tampico, blended with waste material from petitioner's plants, on which, after further processing, rubber was sprayed and the product was then vulcanized and stamped into sizes for upholstery and mattress purposes. The development from hairtex to tulatex was an evolution under petitioner's program*305 to develop a product in the manufacture of which its waste material could be used to obtain the highest price for it. The first sale of the product was made *110 by petitioner in or about September 1939. The product was not commercially acceptable until later. It was manufactured in the same building in which hairtex had been produced. It was necessary for petitioner to purchase considerable additional machinery to produce tulatex. The cost of the new machines was not very much, but changes necessary to make them operate properly were very expensive.
The crude materials used in the production of hairtex and tulatex were charged to the accounts maintained for the hairtex and tulatex departments at cost to petitioner and in certain instances at amounts slightly below cost. Waste materials were charged to the accounts at the current price for which the materials could have been sold to outside customers. In the fiscal years 1937 to 1940, inclusive, respectively, the amount of waste material so charged to the hairtex-tulatex accounts was 35.98 per cent, 22.48 per cent, 10.53 per cent, and 5.85 per cent of the total amount charged, and 14.66 per cent of the total for the four*306 years. Petitioner did not at any time during the fiscal year 1940 or the four previous taxable years maintain separate accounts for experimental or development activities.
To increase their business, manufacturers of compounded latex, a component of tulatex, placed their technical staffs and laboratories at the disposal of petitioner without charge to petitioner, but at great expense to them, to assist petitioner in the development of a satisfactory latex compound for its purpose. Equipment manufacturers, for the same reason, placed their engineering staffs at the disposal of petitioner. Before petitioner completed the installation of its first production line, it received such large orders from two automobile manufacturers that it was forced to operate three shifts a day seven days a week and to increase the number of employees engaged in producing the article. As soon as the installation was completed, petitioner immediately commenced to install a new production line to triple its production of tulatex. No intensive selling or promotion campaign was necessary to effect such rapid development of sales. Tulatex was not adopted for use in automobiles until the summer of 1940 *307 or the beginning of the 1941 season for automobiles. Net sales of tulatex increased from $ 43,521 in the fiscal year 1940 to $ 1,020,865 in the next fiscal year.
The accounts kept by petitioner for its hairtex and tulatex departments disclosed operating losses (including general expenses allocated in part to the department) of $ 20,400.66, $ 23,687.26, $ 8,530.96, $ 15,396.25, and $ 65,526.30 during the fiscal years 1936 to 1940, inclusive, respectively. The allocated expenses were $ 20,406.04 in 1940 and a total of $ 27,111.35 for the prior four years. The charges in the account for repairs to machinery and equipment under the heading "Indirect costs" were $ 4,587.48, $ 2,171.89, $ 407.29, and $ 618.79 for the respective fiscal years 1936 to 1939, inclusive. The charges in *111 the account in 1936 and 1939 for crude material received were $ 29,965.16 and $ 11,242.72, respectively. The loss in 1940, as disclosed by the books, was sustained, in part, on account of experimental work still being conducted, and changes in machinery. The tulatex department account for 1940 contained the following entries:
| TWELVE-MONTH PERIOD ENDED MAY 31, 1940 | ||||
| Sales: | $ 44,641.11 | |||
| Selling expense | $ 1,210.22 | |||
| Administrative expense | 12,681.00 | |||
| Discounts allowed | 1,119.27 | |||
| 15,010.49 | ||||
| Cost of material consumed: | $ 29,630.62 | |||
| Inventory -- finished stock June 1, | ||||
| 1939 | 8,035.49 | |||
| Inventory -- goods in process June | ||||
| 1, 1939 | 1,802.18 | |||
| Crude material received | 29,901.03 | |||
| 39,738.70 | ||||
| Goods in process May 31, 1940 | 11,229.93 | |||
| Inventory -- finished stock May 31, | ||||
| 1940 | 17,880.97 | |||
| 29,110.90 | ||||
| 10,627.80 | ||||
| Indirect costs: | ||||
| Indirect labor | 4,507.12 | 19,002.82 | ||
| Machine shop labor | 4,407.46 | |||
| Indirect supplies | 22,035.50 | |||
| Repairs: | ||||
| Buildings | 3,186.74 | |||
| Machinery and equipment | 13,103.99 | |||
| Team and truck | 25.84 | |||
| Team and truck expense | 145.64 | |||
| Light -- power -- gas | 2,322.69 | |||
| Heat -- boiler house expense -- | ||||
| steam | 5,250.01 | |||
| Taxes, city | 450.00 | |||
| Fire insurance | 88.43 | |||
| Liability insurance | 79.96 | |||
| Group insurance | 106.65 | |||
| Depreciation: | ||||
| B & I buildings | $ 31.36 | |||
| Machinery and equipment | 2,530.26 | |||
| Frame buildings | 14.52 | |||
| Brick buildings | 85.47 | |||
| Truck | 76.77 | |||
| Rent | 950.00 | |||
| Depreciation, automobile | 27.35 | |||
| Bonus | 494.22 | |||
| 59,919.98 | ||||
| Manufacturing overhead: | ||||
| Superintendence | $ 2,850.00 | |||
| Factory clerical | 1,495.77 | |||
| Nonproductive labor | 749.33 | |||
| Supplies -- unclassified | 163.18 | |||
| Taxes | 450.00 | |||
| Fire insurance | 88.43 | |||
| Paymaster insurance | 1.80 | |||
| Check forgery insurance | 2.85 | |||
| Water | 469.62 | |||
| Miscellaneous expenses | 3,047.85 | |||
| $ 9,318.83 | ||||
| Direct labor | 15,290.31 | |||
| $ 84,529.12 | ||||
| Operating loss | 65,526.30 |
*308 *112 It had been the policy of petitioner for years to maintain separate accounts on its books for manufacturing departments of its business to enable it to determine the cost of operation in each department. In addition to hairtex or tulatex, it maintained accounts for dyeing, hacking, cutting, combing, patents, bass, and hair.
Balance sheets in tax returns of petitioner reported the following figures, omitting cents:
| Machinery and | Machinery and | Capital and | ||
| Year ended May 31 -- | equipment | equipment, | Total assets | surplus |
| account | Baldwin plant | |||
| 1936 | $ 96,310 | $ 1,611,931 | $ 1,480,250 | |
| 1937 | 99,855 | 1,802,023 | 1,802,023 | |
| 1938 | 108,441 | $ 46,887 | 1,873,313 | 1,175,696 |
| 1939 | 111,332 | 52,172 | 1,740,859 | 1,210,144 |
| 1940 | 130,141 | 68,616 | 1,812,130 | 1,344,093 |
| 1941 | 185,413 | 150,365 | 2,197,880 | 1,516,624 |
The transfer of machinery from petitioner to the Tulatex Corporation was made at the figure of $ 137,167.59, out of a total of $ 300,044.07. The machinery transferred had been acquired by petitioner in and after 1935 to produce hairtex and tulatex. During that period there was an expansion in the capacity of the plant. There was a change in the type, size*309 and character, condition, and manner of operation of petitioner's business during the fiscal years 1936 to 1940, inclusive, and the excess in "loss" deductions claimed by petitioner was a consequence of such change.
Petitioner filed a claim for relief under section 722 of the Internal Revenue Code for the fiscal year 1941, upon the ground that the character of its business had changed from the manufacture of brush fibers in its base period years 1937 to 1940, inclusive, to manufacture of brush fibers and tulatex pads as of June 1, 1940. Petitioner was allowed a *113 constructive average base period net income for such fiscal year as claimed therein.
The application contained a statement of income for the fiscal year 1941 in which normal tax net income of $ 442,872.34 was ascribed to the production of tulatex and brush fibers in the respective proportions of 30.515 per cent and 69.485 per cent, by deducting from gross profit on sales of each amounts for all of the expenses of petitioner, except interest, all of which was charged to the manufacture of brush fibers The ratios so determined were then applied to the four previous taxable years of petitioner to determine what its *310 normal tax net income would have been in such years if the character of the business had been the same in the base period years. The method so applied resulted in increasing the normal tax net income by $ 117,328.94, $ 38,660.21, $ 50,949.24, and $ 105,837.80 in the respective fiscal years 1937 to 1940, inclusive.
No claim was made by the petitioner in its returns for the taxable years for relief under the provisions of section 711 of the code. The income, declared value excess profits, and excess profits taxes shown to be due in the returns filed by petitioner for the taxable years were paid by petitioner in installments during the next fiscal years, respectively.
On January 12, 1943, the petitioner filed a claim for refund of excess profits tax paid for the fiscal year 1942 in the amount of $ 12,379.62, based upon the retroactive repeal of section 710 (a) (2) of the Internal Revenue Code by section 229 (a) (2) of the Revenue Act of 1942. The contention made by the petitioner in the claim was allowed by the respondent in connection with his determination of the deficiencies involved herein, but the claim for refund was disallowed because other adjustments resulted in a deficiency*311 in excess profits tax.
On March 21, 1946, the petitioner filed a claim for refund of taxes paid for the fiscal year 1943, based upon failure to claim as a deduction $ 50,000 for additional salary for Unsworth.
In a written protest submitted by the petitioner against the findings of a revenue agent for the taxable years, received January 2, 1945, petitioner contended that losses in its tulatex department for the base period years 1937 to 1940, inclusive, as set forth therein, were abnormal deductions under section 711 (b) (1) (J) of the Internal Revenue Code, that they should be added back to the income of the years involved to determine the average base period net income, and that section 711 (b) (1) (K) provides certain conditions for the application of section 711 (b) (1) (J). It also contended that the abnormal deductions were not a consequence of an increase in its gross income; that the losses were not accompanied by a decrease in the amount of some other deductions *114 in the base period; that the losses were not symptomatic of any change in the type, manner of operation, size, or condition of the business, within the meaning of section 711 (b) (1) (J); that there was*312 no occasion for the application of section 711 (b) (1) (K) (iii), because petitioner had no deductions in the taxable years of a class similar to the tulatex losses; that the losses were of a class "abnormal for the taxpayer within the meaning of section 711 (B) (J) (I)" and it was not necessary to determine the average amount of such losses for the four prior years.
On March 12, 1947, petitioner submitted a statement to respondent in support of its contention "for an adjustment of excess profits tax for the fiscal years 1942 and 1943 under Section 711 (b) (1) (J) of the Internal Revenue Code." Summaries of the operating losses of the hairtex and tulatex departments of petitioner for the years 1936 to 1940, inclusive, were attached to the statement. The statement concludes with the following remarks:
* * * Unless the Tulatex losses are removed in the computation of base period net income the company's income credit has been distorted by a factor which reduced base period net income but was not available to reduce the excess profits net income of the taxable years. This is precisely the kind of situation which Section 711 (b) (1) (J) was intended to relieve.
The claim was disallowed*313 on March 26, 1947, by a letter, in which, after referring to the petition instituting this proceeding and a conference held on February 26, 1947, petitioner was informed that his proposal of settlement of this proceeding was unacceptable, "for the reason that deductions have not been grounded in appropriate class or classes, nor does the record establish that they were not a consequence of one or more of the factors enumerated in section 711 (b) (1) (K) (ii) of the Internal Revenue Code."
The statement attached to the deficiency notice herein, mailed May 22, 1946, referred to petitioner's contention that some of its expenses for the base period "were abnormal within the meaning of section 711 (b) (J) of the Internal Revenue Code, and should not have been deducted for those years"; that information on file in the Commissioner's office indicated that utilization of waste material in the manufacture of tulatex had resulted in a reduction of $ 1.20 in the cost of 100 pounds of material, and informed petitioner that after careful consideration of its contentions it had been determined "that you have not established your right to have the operating losses of developing the Tulatex products*314 added back to the income of the years involved to determine the average base period net income within the meaning of section 711 (b) (J) of the Internal Revenue Code."
*115 OPINION.
Three questions are presented for answer. For clarity we separate them by headings:
Compensation of Unsworth.
Petitioner contends that the compensation paid Unsworth was reasonable, considering his unique abilities, the additional services rendered by him during the taxable years, and the normal practice with respect to executive compensation. It says that the increase in salary and bonus from $ 66,000 in 1941 to $ 123,000 in the taxable years was in fair proportion to the increased value of his services.
The sales of petitioner in 1942 increased about 43 per cent over 1941 and the increase in net income before officers' salaries and bonuses was 115 per cent. The increase in salary and bonus of Unsworth was about 85 per cent. In 1943, when the salary and bonus were the same, there was a decrease of about .8 per cent in sales as compared with those in 1942, and net income was only about 52 per cent of the net income for the previous year. If the ability of Unsworth as an executive was responsible*315 for the financial success of petitioner in 1942, it was not reflected in the earnings of the succeeding year in comparison with other years. Part of the increase in profits in 1942 was directly attributable to the advantageous purchase of raw material. The purchase of raw material was an ordinary transaction in the life of a corporation like petitioner, and the particular purchase relied on, though indicating close attention to business by Unsworth, was within his ordinary duty and was made by outbidding competitors. It did not require any particular or peculiar ability. We think petitioner overweighs it. Commencing with the fiscal year 1942, Unsworth, as an officer of petitioner, no longer had any executive duties respecting the production of tulatex, which had taken up a considerable part of his time in previous years. Net sales of tulatex in 1941 were about 28 per cent of total sales. The business of petitioner has always involved one of developing substitutes to meet the demands of its buyers. Inability to obtain its usual supply of raw materials increased petitioner's problems to meet trade requirements, but its position in the industry overcame much of the usual marketing*316 problems. The knowledge of Unsworth was not petitioner's only source for preparation of new formulae for brush fiber.
It does not appear that Unsworth's duties as a salesman differed in any material respect in the taxable years from prior years. The fact that petitioner employed no salesman especially to market its product is indicative of the monopolistic nature of its business. Evidence of its unique position in the brush fiber field is contained in the fact that a substantial part of its sales resulted from orders received without *116 solicitation. In effect, petitioner had not the sale problems usual to ordinary manufacturers.
The services rendered by Unsworth in organizing Fibras Duras are relied upon by petitioner as special duties of important benefit to it. The foreign corporation was formed and owned by Unsworth for the primary purpose of insuring a supply of material for the Tulatex Corporation, which acquired about 90 per cent of its output, the remainder going to petitioner. The services rendered by Unsworth in that regard benefited himself, personally, petitioner, and its subsidiary, in proportions indeterminable from the record. Some time was devoted to *317 that activity by Unsworth during the fiscal year 1942, the exact amount not appearing. His own estimation of the time spent was that he was "on the go constantly" to the Mexican border and in the interior of Mexico. This testimony indicates generally a considerable portion of his time given to Fibras Duras, and is evidence of the ability of subordinates of Unsworth to manage petitioner's affairs, including sales and production, without his presence at the plant. While petitioner was otherwise indirectly benefited through its ownership of all of the stock of the Tulatex Corporation, the latter corporation was the principal beneficiary, and most of Unsworth's services must be regarded as having been rendered as an official of it, for which he received a salary, rather than for petitioner. In any event, the circumstances are against regarding all of the services as having been rendered for petitioner. The services, rendered only in a small part for petitioner, influenced the voting on February 28, 1942, of the bonus of $ 25,000.
The returns of petitioner for the taxable years reported that Unsworth devoted all of his time to its business, contrary to the evidence here that during*318 such years he also was president and treasurer of the Tulatex Corporation and the Burlington Realty Co., and received salaries from them for his services. The salary from each subsidiary differed in 1943 from the prior year, indicating the existence of some method of measuring the compensation for his services. Unsworth regarded petitioner and its subsidiaries as one entity and admitted that some part of his salary from petitioner was for services rendered to its subsidiaries. The corporations are separate and distinct taxpayers and one may not take a deduction belonging to another. Hal E. Roach Studios, 20 B. T. A. 917; South American Gold & Platinum Co., 8 T.C. 1297">8 T. C. 1297.
The salary of Unsworth as an officer of the Tulatex Corporation was not large in comparison with his salary and bonus from petitioner, the former having been $ 12,000 for the fiscal year 1942 and $ 8,500 for 1943. His services for the Tulatex Corporation during the taxable years were important and took some of his time, occasionally a great deal.
Upon brief, petitioner admits that it is probable that the subsidiary *117 received some benefit from*319 the services. Unsworth never gave any thought as to whether he was serving the petitioner, Queen City Tulatex Corporation, or Burlington Realty Co., all of which operated from the same office, a practice consistent with his personal opinion that there was only one entity for him to serve.
We find no evidence sufficient to support a conclusion that the bonuses were in recognition of services of Unsworth in prior years. To the contrary is the resolution adopted April 18, 1942, which provides that the bonus of $ 50,000 was "for his services rendered during the present fiscal year."
The record indicates particular generosity by the petitioner during the taxable years when its net income greatly exceeded those of prior years. Consideration of "financial success" and of the fact that "earned surplus was excellent" affected the directors' action on April 18, 1942, and May 29, 1943, respectively, the dates of resolutions authorizing bonus to Unsworth. This indicates doubt as to whether services actually rendered were being recompensed.
Several witnesses testified for petitioner on the reasonableness of the salaries in question. One, a director of petitioner after August 18, 1942, who*320 voted for the bonus in the fiscal year 1943, did not disclose much knowledge of salaries paid executives of corporations comparable in size to petitioner and was not familiar with the dividend record of petitioner until informed of it while on the witness stand, and he was an interested witness. It does not appear that he took into consideration the duties Unsworth had as an officer of the subsidiary corporations. Another witness testified to the reasonableness of the salary and bonus of $ 123,000, if "it is based on services rendered to the Whiting Company," but based his opinion to a large extent on the fact that the corporation of which he was chairman of the board of directors, which had sales of about $ 20,000,000 in 1946, would have paid Unsworth such a salary for full time services. This tends to indicate a lowered figure under the facts here present. The third witness, who was president of a corporation producing brushes from material purchased from petitioner, and household chemicals, testified that he would pay Unsworth 2 or 3 or 4 per cent of sales for his services in a fiber business. At the rate of 2 per cent of sales, Unsworth's salary would have been about $ 102,000. *321 The salary of the witness was $ 110,000 when the corporation of which he was president had net sales of about $ 14,000,000. The remaining witness, an experienced investment banker who disclosed familiarity with petitioner's business and Unsworth's duties with it for many years, testified that the salary of $ 123,000 was reasonable. His opinion must be viewed in the light of other of his testimony that in about 1926 (when Unsworth was about 50 years old), he would have recommended a salary of $ 75,000 for Unsworth to serve as president of a consolidation of corporations, *118 including petitioner, representing about 70 per cent of the brush business, to produce brush material and brushes.
We think that respondent failed to give full weight to the outstanding qualifications of Unsworth in the brush fiber industry, all of which benefited petitioner, particularly in the taxable years, when lack of raw material required the production of substitute products. On the other hand, there is evidence that some part of the compensation voted for Unsworth was for services rendered to the Tulatex Corporation and on account of increased profits having no direct relation to extra services.
*322 It is apparent that considerable of his time was devoted to Fibras Duras, his own corporation, a fact detracting in no small degree from the value of his services to the petitioner. The record does not show how much, and the witnesses reveal no greater knowledge on the point. That the directorship of a corporation votes compensation is entitled to much weight, but the logic of that rule grows thin when, as here, the beneficiary is largely in command of the corporation, and self-interest may affect sound business judgment, upon which that rule is necessarily based. Unsworth and his family held too much stock in the petitioner for great weight to be given the mere fact of directors' authorization. In our view, he is seen as a valuable man, but, balancing and evaluating all evidence before us, we think it fails to justify the figure asked. From all of the evidence we have found as a fact that $ 90,000 constitutes reasonable compensation for personal services of Unsworth for each of the taxable years.
Accrual of $ 50,000 Bonus in 1943.
The aggregate salary and bonus authorized for Unsworth for the fiscal year 1943 was $ 123,000, of which only $ 73,000 was claimed as a deduction*323 in petitioner's return for that year. The respondent allowed $ 51,000 of the amount as a deduction and disallowed the remainder as representing compensation in excess of a reasonable amount. The question here is whether the bonus of $ 50,000, or more particularly $ 17,000 thereof, the difference between the salary of $ 90,000 held by us to be reasonable and the amount paid by petitioner, is accruable in that year. The issue was raised to insure the allowance of the amount in 1943 or the next year, when paid.
The resolution authorized a bonus "up to but not to exceed $ 50,000," provided "that said bonus should be paid at such time as in the discretion of the treasurer finances of the corporations will permit."
Petitioner argues that as the services were rendered and unconditional and fixed liability was incurred in the taxable year, the amount was accruable at that time.
The resolution did not fix the amount of the bonus, other than that it was not to be in excess of $ 50,000. There is no indication in *119 the record that Unsworth determined upon the amount of his bonus prior to actual payment of the last amount in December 1943, and it does not appear that petitioner ever*324 accrued any of the bonus on its books.
Payment of the bonus was contingent upon the condition of petitioner's finances, the determination of which, like the amount, was left to the treasurer, who was Unsworth. Upon brief petitioner makes no contention that its finances in the fiscal year 1943 were such as to permit payment of the amount and the record is silent on whether Unsworth considered or reached a conclusion on the matter within the taxable year. The fact that nothing was paid on the obligation until September 1943 is some evidence that petitioner's finances prevented payment in the taxable year.
At the meeting during which the bonus was authorized, the directors approved the payment of an additional bonus to employees during the fiscal year 1943. The fact that such a direction was given in the case of employees and not with respect to the bonus authorized for Unsworth indicates their lack of definite action on the time of accrual or payment of the bonus for Unsworth.
In Ames Reliable Products Co., 44 B. T. A. 176, $ 10,000 of a bonus of $ 12,000 was made payable by a resolution "when all outstanding bonds have been retired and the cash position*325 of the Company warrants." We held that the resolution did not create a fixed or certain obligation to pay and that the contingency prevented accrual of the amount in the taxable year as a liability. A similar contingency was present in Harrington Co., 6 T. C. 720, in which we held that the expense was not incurred in the taxable year involved therein.
In Anderson-Clayton Securities Corporation, 35 B. T. A. 795, cited by the petitioner, the liability for payment of net profits was determined in the taxable year and the amount thereof was not ascertained until the next year. Here only the maximum amount was fixed and liability was conditioned upon future events, which might never occur. On this issue we sustain the respondent.
Loss Disallowance -- Sec. 711 (b) (1) (J) (ii).
In his answer to the amended petition filed herein at the hearing the respondent affirmatively alleged that the petitioner failed to comply with the provisions of section 35.711 (b)-2 (a) and (b) of Regulations 112, relating, in general, to classification of deductions under section 711 (b) (1) (H), (I) and (J) of the Internal*326 Revenue Code, accompanied by a statement in support of a claim for disallowance of deductions under one or more of such subparagraphs. He contends upon brief not only that there was no compliance with the regulations, but that no refund claim was ever filed, claiming the benefits of section 711, and, accordingly, none was ever disallowed.
*120 While the respondent did not question our jurisdiction in any of his pleadings, the nature of his argument suggests that the filing and rejection of a claim for refund must have occurred to give this Court jurisdiction. We can not agree. A deficiency was determined and question arises under section 711 (b) (1) (J). Neither section 732 nor any other requires denial of a claim for refund as a prerequisite to our jurisdiction. The requirements as to section 722 do not apply as to section 711 (b) (1) (J). They were present in the law from 1940 and prior to the later amendments as to payment and refund claim under section 722. Section 729, from and after 1940, applied to the subchapter on excess profits taxes all provisions of law applicable to taxes imposed by chapter 1 of the code, and, therefore, applied the provision as to appeal *327 from a determination of a deficiency involving section 711 (b) (1) (J). We conclude that we have jurisdiction.
In the light of the conclusions hereinafter reached by us, we pass as unnecessary of consideration the point as to whether petitioner complied with the regulations issued under section 711 (b) (1) (J).
The petition and amended petition alleged as error the failure of respondent to increase petitioner's excess profits credit each year by restoring to its base period years the amounts of its "abnormal" losses incurred in the development of tulatex, citing section 711 (b) (1) (J)1*329 and refusing refunds to it based upon adjustments under that subparagraph. The allegation of facts in the amended petition states that such losses for the fiscal years 1936 to 1940, inclusive, reasonably constituted a separate class of deductions under section 711 (b) (1) (H) of the code; that the loss sustained in the development and sale of tulatex in the fiscal year 1940 was abnormal, citing section 711 (b) (1) (J) (i) and that the amount of $ 65,526.30 should be disallowed in computing its excess profits net income for that year. Allegations of fact are then made in the alternative, citing *328 section 711 (b) (1) (J) (ii). The petition and amended petition make no reference to section *121 711 (b) (1) (K), paragraph (ii) of which is set forth in the margin, 2 but allege that the operating loss deduction for 1940 was not a consequence of increase in gross income nor of decrease in some other deductions, in the base period -- elements required by subparagraph (K) (ii).
The applicability of section 711 (b) (1) (H)3 is not discussed by the petitioner upon brief, in view of which it will be assumed that it no longer relies upon that provision of the statute. On the face of that subdivision, it is clear that it does not in terms apply; nor can it be applied by any interpretation we consider possible. Petitioner pleads that the operating loss in the tulatex department for the fiscal year 1940 should be disallowed under "section 711 (b) (1) (J)" in computing *330 its excess profits credit. The respondent's rejection of petitioner's claim for refund was a general denial of petitioner's establishment of any right to adjustments under section 711 (b) (1) (J). Petitioner's burden here was to prove facts bringing the loss for 1940 within subparagraph (J).
Petitioner now on brief concedes that the tulatex expenses for 1940 were not abnormal as to class, but says that they were abnormal as to amount. It further concedes that the operating loss in that year of $ 65,526.30 should*331 be reduced to $ 45,120.26 by excluding therefrom all allocated costs which were included in arriving at the former figure. It then argues that the actual costs, amounting to $ 45,120.26, should be restored to the net income for 1940 to the extent that they exceed 125 per centum of the average of like costs, adjusted by eliminating allocated items of expense, for the four preceding taxable years. By such a method it arrives at the figure of $ 32,330.34 for adjustment of excess profits net income for 1940.
Thus, it is seen that the petitioner no longer relies upon subparagraph (J) (i) and is now seeking relief only under subparagraph (J) (ii), and under it only for an adjustment in 1940, upon the ground *122 that such restoration gives it greater relief under the statutory growth formula in section 713 (f).
To be entitled to an application of subparagraph (J) (ii), petitioner must establish that the loss sought to be applied as an adjustment represents a classification of deductions within the meaning of the statute. The petitioner contends that the expenses which created the loss are a proper classification of deductions and cites section 35.711 (b)-2 (a) of Regulations*332 112, reading, to the extent material, as follows:
Deductions which do not fall within either of the classes specified in section 711 (b) (1) (H) and (I) may be grouped by the taxpayer, subject to approval by the Commissioner on the examination of the taxpayer's return, in such other classes as are reasonable in a business of the type which the taxpayer conducts, and are appropriate in the light of the taxpayer's business experience and accounting practice. Such a classification will be applicable to all other taxable years considered at any time in adjusting deductions under this section, and must be consistent with any classification made by the taxpayer under the provisions of section 721 and section 722.
Respondent contends that the term deduction "Represents those amounts which go to reduce gross income and to produce net taxable income"; that it does not permit a reclassification of deductions to produce a loss not properly deductible under section 23 (f); that the tulatex account in which the loss occurred was maintained for internal control; and that the statute does not recognize classification of departments of a business. He admits that the expenses included to make *333 up the losses are "deductions."
The loss each applicable year, without allocated amounts, was computed by deducting various expenses from sales, with adjustments for cost of crude material and opening and closing inventories.
"The statute * * * is remedial and should be given a reasonable and rational construction." Iron Fireman Manufacturing Co., 5 T. C. 452 (463) It does not require that the classification of deductions necessarily follow deductions taken by the taxpayer under section 23. Green Bay Lumber Co., 3 T. C. 824, in which we held from the peculiar facts involved therein that bad debts of employees constitute a class of deductions different from other bad debts of the taxpayer. Cf. Arrow-Hart & Hegeman Electric Co., 7 T. C. 1350 (1369 and 1379); Oaklawn Jockey Club, 8 T. C. 1128. Petitioner here seeks relief based upon more than a subdivision of a class of deductions normally incurred by it. It is asking that we recognize as a loss, expenses involved in the operation of one of the departments of its business, decreased by sales of the product produced*334 in the department and adjustments for inventory. Petitioner points to no statutory provision permitting as a deduction from gross income the net financial result of the operations of its tulatex department and its predecessor, the hairtex department, and we find none. The amount of such a loss would be affected each year by sales, which are *123 not deductions, and opening and closing inventories, thereby preventing any reasonable comparison of deductible expenses, not at cost to the petitioner, but at the price for which it could be sold. If this does not show that there may, to that extent, have been decrease in petitioner's deduction (within the language of subparagraph (K) (ii)) -- for cost of material, it at least demonstrates the lack of the nature of a true deduction to the petitioner, in the "loss" for which petitioner contends; for it is obvious that the waste material might, per pound or other unit, be sold for more than its original purchase price -- particularly if, such as in the purchase of the ship's cargo at Everglades, Florida, in 1942 (of course not involved in 1940 and mentioned here only by way of example). It appears altogether possible, for instance, *335 that the poundage of waste in istle might, after going through partial processing, be worth more for sale to some other manufacturer than the original cost of istle per pound. In such case, clearly the sales price figure, higher than original cost per pound, when charged to the tulatex department, would tend to increase its "loss" contrary to the fact that petitioner actually paid less for the material. Though the amount of waste may not have been great, pro tanto, there would in such case be no true loss to the petitioner.
The grouping here is of departments, and not deductions. The flexibility of the method is illustrated by the concession of petitioner that the operating loss of $ 65,526.30, as originally claimed, should be reduced by the items therein, totaling $ 20,406.04, representing allocations of general expenses, including selling, administrative, insurance, and depreciation. Thus the amount now being claimed as a class of deductions is exclusive of certain indirect costs and no longer represents the original account. In its present form the account does not represent the "loss" of the tulatex department.
Petitioner's auditor, who supervised the keeping of its books, *336 testified that items in the account for 1940 other than amounts reached by allocation methods were actual and direct costs. The transcript of the account discloses otherwise. Under the heading of "Indirect costs" appears an amount for indirect labor and indirect supplies. An item of $ 15,290.31 for direct labor is listed at the bottom of the summary. The division of labor charges is inconsistent with the testimony of the witness. The account also includes an amount for repairs to buildings. Nothing of record is contrary to the idea that at least some part of the amount charged in the account for repairs to buildings resulted from ordinary wear and tear to the property, repairs that would have been necessary without use of the building to produce tulatex. The amount in the account for repairs to machinery and equipment, when compared with prior years, indicates that it contains charges for property chargeable to other accounts. Considerable expense was *124 incurred in the fiscal year 1940 in altering machinery to produce tulatex satisfactorily. No proof was made that such capital costs were not charged to repairs. Substantially the same amount of crude material was *337 received in the department in 1936 and 1940, yet only $ 4,587.48 was charged for repairs in the former year against $ 13,103.99 in the latter year. In 1939, when crude material received amounted to $ 11,242.72, or about 37 per cent of 1940, the repair charges were only $ 618.79.
A similar situation prevailed in Consolidated Motor Lines, Inc., 6 T. C. 1066. There the petitioner sought to treat increased ordinary expenses caused by a hurricane as a loss deduction within section 711 (b) (1) (E). We held that the expenses were not losses.
The regulations require that any grouping of deductions in a class under subparagraph (J) be consistent with any classification made by the taxpayer under the provisions of sections 721 and 722. Sec. 35.711 (b)-2 (a), Regulations 112.
In its application, filed on Form 991, for relief under section 722 for the fiscal year 1941, based upon a change in the character of its business by the manufacture of tulatex, in 1941 petitioner charged to tulatex a portion of all of its expenses, except interest paid, and determined, by deducting such expenses from gross profit on sales, that of its normal tax net income, 30.515 per*338 cent thereof was attributable to tulatex and the remainder of 69.485 per cent to production of brush fibers. Those ratios were used for determining like income for the base period years 1937 to 1940, inclusive. The grouping of "deductions" there involved a comparison of sales of each class of products in the taxable year 1941, and an application of the result to base period years. The grouping here is of a different kind, being a comparison of expenses of producing and selling tulatex alone. Under the method used in the application under section 722, normal tax net income for 1940 in the amount of $ 241,000.80 was increased by $ 105,837.80 to determine what such income would have been if tulatex had been manufactured in that year. Normal tax net income in each of the prior base period years was increased in the same proportion by the same method. Here a "loss," and not increased net income, is being claimed each base period year in the production of hairtex or tulatex.
The application under section 722 contained deductions for selling expenses which are eliminated here under petitioner's concession. There in 1941 tulatex absorbed $ 70,176.67 of the total administrative expense*339 of $ 118,446.26. Here, the charges under the heading "administrative expense" are not taken into account, but some of the accounts, classified there as administrative expenses, are included in the years involved herein as charges under "Indirect costs" and "Manufacturing overhead." The accounts here contain charges for "Indirect Supplies," *125 the amount for 1940 being $ 22,035.50. We find no such account, or one for "Machine Shop Labor" in the claim under section 722. Under the circumstances, it appears that the grouping here is not consistent with the classification made by the petitioner in its application for relief in 1941 under section 722.
Considering all of the facts, we conclude that the tulatex department account and its predecessor, with or without the concession of petitioner as to allocated charges, do not constitute a class of deductions within the meaning of subparagraph (J) (ii).
Moreover, even if the "loss" involved was a deduction within section 711 (b) (1) (J) (ii), in our opinion the petitioner has the burden of establishing, under section 711 (b) (1) (K) (ii), that the excess amount involved in such deduction is not a consequence, inter alia, of a*340 change in type, manner of operation, size, or condition of its business; and that it has failed so to establish. The petitioner took the view at trial that because of the nature of the Commissioner's reference to section 711 (b) (1) (J) in the deficiency notice, in referring to decreased costs, it had not the burden of showing lack of consequence of change in type, manner of operation, size, or condition of business. Its amended petition pleads that the loss was not a consequence of increase in gross income or decrease in other deductions. But for the same reason which above caused us to hold that a claim under section 711 (b) (1) (J) was filed and rejected, we hold that the petitioner has as to all of the elements therein specified by subparagraph (K) (ii) the burden therein cast upon it. William Leveen Corporation, 3 T. C. 593; R. C. Harvey Co., 5 T. C. 431; Wentworth Manufacturing Co., 6 T. C. 1201; Harris Hardwood Co., 8 T. C. 874. The claim was not presented in the return, but in a protest, and was discussed in conference. The respondent urges that *341 there was no claim presented, but we have above concluded that there was; but we also think that, in the absence of more definiteness in claim, the petitioner can not be heard to say that the rejection in the deficiency notice should be held to the narrow limits proposed. The petitioner on brief, arguing against the respondent's contention that regulations had not been complied with, alleged that in the notice of deficiency the Commissioner had used the language of subparagraph (K) (ii) in holding that petitioner had not established its right to restore the tulatex losses to base period net income, and added: "These statements can only be interpreted as a finding that petitioner had not met the requirements of paragraph (K) (ii) of the section" -- going on to contend that the rejection was for certain definitely stated reasons. Assuming that the deficiency notice is a rejection under subparagraph (K) (ii), as petitioner says, we do not agree that the reasons were definitely limited, but agree that subparagraph (K) (ii) was covered, and *126 consider it covered in general, and that the reference to decrease in costs does not limit the rejection. The rejection refers to "your*342 contentions," not certain contentions, and then states that petitioner's right to have operating losses added back to income have not been "established." If the Commissioner was correct, his reasons need not be detailed. The expression is obviously general, and not limited to one element of subparagraph (K) (ii). The statute provides that deductions shall not be disallowed (under subparagraph (J)) unless the petitioner establishes that the excess is not a consequence of the elements here considered. We see no reason here to relieve the petitioner of that burden. Moreover, the respondent pleaded in the alternative that there was change in type, etc., within subparagraph (K) (ii), and the petitioner replied denying that the abnormality was a consequence of such change, and it argues that the question is squarely presented by the pleadings, and that it has established that none of the factors specified in subparagraph (K) (ii) prevents disallowance of the claim. It thus appears that it may be that the petitioner does not now deny its burden in this respect. Regardless of burden, we think the facts of record show that requirements of subparagraph (K) (ii) are absent. Pepsi Cola Co., 5 T. C. 190.*343
At a time prior to the present controversy, the petitioner asked for relief under section 722 of the Internal Revenue Code for the fiscal year 1941. The basic reason advanced therefor was that "the character of the business" on "January 1, 1940" (apparently meaning June 1, 1940), was "Mfg. of brush fibres and tulatex pads," whereas the "character of the business" in each of the base period years had been "different," that is, had been "Manufacture of brush fibres." Though recognizing that it has been said that "change in character" of business under section 722 is not synonymous nor interchangeable with "change * * * in the condition of the business" under section 711 (b) (1) (K) (ii) ( Arrow-Hart & Hegeman Electric Co., 7 T. C. 1350, 1379), nevertheless, we note that under the text of section 722 (b) (4), "'change in the character of the business' includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, * * *." It is clear that at that time the petitioner took the view that there was a change "in the operation or management of the business," *344 and we would be wholly unrealistic were we not to hold on the facts that here this is the same as change in the manner of operation and condition of the business, within the intendment of section 711 (b) (1) (K) (ii). Particularly, we can not doubt that there is no essential difference between change in operation and change in manner of operation; nor that at an earlier time the petitioner properly so considered, when proceeding under a statute which, *127 like the one here considered, involved the ascertainment of normal income. We think the language then used may be more safely relied on, as petitioner's appraisal of the facts involved, than the petitioner's present arguments (though the petitioner was not estopped to change view); moreover, that plainly there had been a change in manner of operation of the petitioner's business, involving manufacture of a new and greatly sought product not theretofore manufactured. The "loss" or deduction here involved was incurred in making the change. Indeed, the petitioner requests a finding of fact that the loss "was sustained because various experiments were still being made, because petitioner kept changing the kind of prepared material*345 it was attempting to make, and because the necessary changes in machinery were very costly." All this is encompassed in change in manner of operation and condition of business. The argument that the experimental stage was not "change" within the statute neglects the fact that sales of the product were being made in the fiscal year 1940 (in September 1939), and that there was, because of acquisition of machinery for tulatex products, expansion of plant capacity from 1935; and that the 1940 loss is therefore seen to be from both experimentation and selling the product.
The petitioner states on brief that it is clear that by the end of the base period a new product had been developed, and maintains that "such new product was the consequence of, and was made possible by, the experiments and expenses of the Tulatex department, principally those of the fiscal year 1940." The record shows the experiments continuing in 1940, and on brief the petitioner says they reached a climax near the close of that fiscal year. Elsewhere, the petitioner urges that the loss in 1940 "was due to two factors, (1) the experiments and the resulting labor, materials and repair costs and (2) its inability to*346 make greater sales of Tulatex or to secure a better price * * *." Again: "It was the constant changes in materials and in adaptation of the machinery that restricted petitioner's volume of production and sales of Tulatex, and produced the loss."
Thus it appears that the petitioner affirmatively charges the loss in part to the experimentation. Its earlier view was that the loss was abnormal in class. (That greater sales were not made at a profit to offset the loss, does not, in our view, detract from the fact that the loss was primarily a consequence of the experimentation in developing the new product.) This case, therefore, in our view, falls within the decision in Surface Combustion Corporation, 9 T. C. 631, where expenses of experiments as to "Kathabar" to perfect air conditioning apparatus were denied disallowance under section 711 (b) (1) (J) (i) for the reason that the requirements of subparagraph (K) (ii) had not been met, we finding that there the expenditures were a consequence of change in type of business. There, as here, only one department *128 of the petitioner's business was involved and a new product was developed for sale. In*347 coming to our conclusion we said: "The need for all of those research and development expenses was occasioned by petitioner's entrance into a new field of business." There is no essential difference here.
The petitioner was entering and was in 1940 in a new field of business, that of manufacturing and selling an important product not theretofore produced by it. It had earlier sold certain waste as such. Now it manufactured it, to some extent, into a finished product, after many experiments and with different machinery than before used. Indeed, the petitioner itself minimizes the connection of the tulatex pads manufactured with the waste formerly sold, for, on brief, it is argued that the experimental development of tulatex was started in January 1938, that in 1939 the waste utilization was largely abandoned and "The percentage of waste employed in the operation in 1940 was insignificant in relation to the size of the experimental program," and that there was "a concerted drive for development and sale of a new product." Thus, there was largely a new product. That is just the case in Surface Combustion Corporation. As in the Surface Combustion case, there was acquisition*348 of a license to produce air-conditioning equipment, and thereafter experimentation, so here there was acquisition of the "Hairtex" trade name and trade-mark and some machinery followed by experimentation leading to sales of tulatex. In Wentworth Manufacturing Co., supra, we found abnormalities to be a direct consequence of change in manner of operation of business, where there was mere employment of inspectors and measures to overcome a manufacturing deficit in that garments were being produced which did not conform to standard sizes. We think that the business here, with the change to tulatex, became as "different" as the petitioner thought when pressing its claim under section 722. Unsworth testified that the development of tulatex constituted a change in the size of the business, and that there was a new branch of business; a new development; that new machinery was purchased. The new portion was in the next year incorporated separately. We hold that the loss and "deduction" urged for 1940 was a consequence of a change in the type and manner of operation and size and condition of the petitioner's business, within the language of subparagraph (K) *349 (ii); therefore, that the amount may not be disallowed in computing excess profits income for 1940.
In view of the conclusion reached by us, it is unnecessary to consider argument of the parties on other points involved under the issue. On this issue we hold for the respondent.
Decision will be entered under Rule 50.
Footnotes
*. Reflects deficiencies involved herein.↩
*. Loss↩
1. SECTION 711. EXCESS PROFITS NET INCOME.
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(b) Taxable Years in Base Period. --
(1) General rule and adjustments. -- The excess profits net income for any taxable year subject to the Revenue Act of 1936 shall be the normal-tax net income, as defined in section 13 (a) of such Act; and for any other taxable year beginning after December 31, 1937, and before January 1, 1940, shall be the special-class net income, as defined in section 14 (a) of the applicable revenue law. In either case the following adjustments shall be made (for additional adjustments in case of certain reorganizations, see section 742 (e)):
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(J) Abnormal Deductions. -- Under regulations prescribed by the Commissioner, with the approval of the Secretary for the determination, for the purposes of this subparagraph, of the classification of deductions --
(i) Deductions of any class shall not be allowed if deductions of such class were abnormal for the taxpayer, and
(ii) If the class of deductions was normal for the taxpayer, but the deductions of such class were in excess of 125 per centum of the average amount of deductions of such class for the four previous taxable years, they shall be disallowed in an amount equal to such excess.↩
2. SECTION 711. EXCESS PROFITS NET INCOME.
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(K) Rules for Application of Subparagraphs (H), (I), and (J) -- For the purposes of subparagraphs (H), (I), and (J) --
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(ii) Deductions shall not be disallowed under such subparagraphs unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.↩
3. SECTION 711. EXCESS PROFITS NET INCOME.
* * * *
(b) Taxable Years in Base Period. --
* * * *
(H) Payment of Judgments, and So Forth. -- Deductions attributable to any claim, award, judgment, or decree against the taxpayer, or interest on any of the foregoing, if abnormal for the taxpayer, shall not be allowed, and if normal for the taxpayer, but in excess of 125 per centum of the average amount of such deductions in the four previous taxable years, shall be disallowed in an amount equal to such excess.↩