*260 Decision will be entered under Rule 50.
1. Petitioner is engaged in the manufacture of milling machines. It was incorporated in 1905 and produced its first machine in 1906. It later manufactured other models of the original type. In 1935 petitioner became convinced that its machines were outmoded and proceeded, through its officers, to create, design, and manufacture a new type of miller calculated to perform functions greater in extent and different in character from those performed by the old machines. During the period from 1936 to 1940, inclusive, large sums were spent in experimenting with and developing the new model, which became commercially successful in 1940 and thus served its desired purpose. Fifteen or more new constituent parts were invented, and adapted and articulated in the new model, which bore only a superficial resemblance to the old type. Petitioner received gross income from the sale of such new machines in 1940 in excess of the 125 per centum of the average amount of the gross income of the same class of the four previous taxable years, as required by section 721 (a) (1), Internal Revenue Code. Held:
(1) The gross income received from such sources*261 resulted from the development of the new machines, and within the provisions of subsection (a) (2) (C) of section 721, and petitioner is entitled to exclude from its excess profits net income the net abnormal income therefrom attributable to the years 1936 to 1939, inclusive, as provided in subsection (c) of section 721.
(2) Only such income as was received in 1940 from the sales of the new machines may be considered in computing the exclusion from petitioner's excess profits net income, other activities of petitioner, such as job work, repair parts, etc., being incidental operations and not contributing to the income from the manufacture of the new machines.
2. The correct method of computing the amount of net abnormal income attributable to prior years determined.
*519 The respondent determined a deficiency of $ 3,161.01 in the excess profits tax of the petitioner for the year 1940.
*520 The sole issue is whether or not the petitioner is entitled to the deduction of abnormal net income earned in the taxable year and attributable to the prior years of 1936 to 1939, inclusive, pursuant to the provisions of section 721, Internal Revenue Code.
FINDINGS OF FACT.
Certain facts were stipulated. The portions thereof material to the issue are summarized as follows:
The petitioner was incorporated under the laws of Missouri on August 3, 1905. Its taxable year is the calendar year and it files its tax returns on the accrual basis. Since its incorporation the petitioner has manufactured and sold Knight milling machines, which are classified as machine tools.
In its tax return *263 for 1940 (Form 1121) filed with the collector of internal revenue for the first district of Missouri, the petitioner computed its excess profits credit on the average earnings method provided by section 713 of the Internal Revenue Code, and at line 11 thereon deducted the amount of $ 10,315.23 as abnormal income attributable to the four preceding years.
The following table shows the sales, cost of sales, and gross profits relating to Knight milling machines, repair parts, and job work done by the petitioner for the period from 1936 to 1940, inclusive:
| (1) | (2) | ||
| Old style | |||
| Calendar year | Total of all | Knight milling | |
| classifications | machines | ||
| 1936 | |||
| Sales | $ 108,499.94 | $ 24,303.27 | |
| Cost of sales | 76,061.33 | 16,334.58 | |
| Gross profit | 32,438.61 | 7,968.69 | |
| 1937 | |||
| Sales | 209,352.71 | 24,684.83 | |
| Cost of sales | 139,455.39 | 15,817.24 | |
| Gross profit | 69,897.32 | 8,867.59 | |
| 1938 | |||
| Sales | 54,631.01 | 6,107.50 | |
| Cost of sales | 39,655.95 | 3,902.19 | |
| Gross profit | 14,975.06 | 2,205.31 | |
| 1939 | |||
| Sales | 148,659.85 | 3,365.50 | |
| Cost of sales | 115,216.97 | 1,893.88 | |
| Gross profit | 33,442.88 | 1,471.62 | |
| Totals for the 4 years | 150,753.87 | 20,513.21 | |
| Average gross profit for years 1936 to 1939, | |||
| incl | 37,688.47 | 5,128.30 | |
| 1940 | |||
| Sales | 424,870.01 | 13,002.75 | |
| Cost of sales | 287,326.72 | 7,469.17 | |
| Gross profit | 137,543.29 | 5,533.58 |
| (3) | (4) | ||
| Model Nos. | Attachments | ||
| 20, 30, and 40 | for Knight | ||
| Calendar year | Knight milling | milling | |
| machines | machines | ||
| 1936 | |||
| Sales | 0 | $ 4,969.53 | |
| Cost of sales | 0 | 3,088.22 | |
| Gross profit | 0 | 1,881.31 | |
| 1937 | |||
| Sales | $ 18,653.75 | 5,628.15 | |
| Cost of sales | 14,537.44 | 3,193.60 | |
| Gross profit | 4,116.31 | 2,434.55 | |
| 1938 | |||
| Sales | 3,700.00 | 1,874.18 | |
| Cost of sales | 2,236.26 | 1,059.29 | |
| Gross profit | 1,463.74 | 814.89 | |
| 1939 | |||
| Sales | 49,788.45 | 4,331.97 | |
| Cost of sales | 40,126.07 | 3,109.22 | |
| Gross profit | 9,662.38 | 1,222.75 | |
| Totals for the 4 years | 15,242.43 | 6,353.50 | |
| Average gross profit for years 1936 to 1939, | |||
| incl | 3,810.61 | 1,588.37 | |
| 1940 | |||
| Sales | 320,498.39 | 39,464.39 | |
| Cost of Sales | 222,908.09 | 22,823.80 | |
| Gross profit | 97,590.30 | 16,640.59 |
| (5) | (6) | (7) | ||
| Calendar year | Purchased | Total of | Repair | |
| attachments | (2), (3), | parts | ||
| (4) and (5) | ||||
| 1936 | ||||
| Sales | $ 682.36 | $ 29,955.16 | $ 1,518.51 | |
| Cost of sales | 631.73 | 20,054.53 | 890.54 | |
| Gross profit | 50.63 | 9,900.63 | 627.97 | |
| 1937 | ||||
| Sales | 184.61 | 49,151.34 | 2,466.24 | |
| Cost of sales | 171.30 | 33,719.58 | 1,495.84 | |
| Gross profit | 13.31 | 15,431.76 | 970.40 | |
| 1938 | ||||
| Sales | 249.50 | 11,931.18 | 737.24 | |
| Cost of sales | 213.32 | 7,411.06 | 426.49 | |
| Gross profit | 36.18 | 4,520.12 | 310.75 | |
| 1939 | ||||
| Sales | 840.60 | 58,326.52 | 1,152.35 | |
| Cost of sales | 706.22 | 45,835.39 | 842.87 | |
| Gross profit | 134.38 | 12,491.13 | 309.48 | |
| Totals for the 4 years | 234.50 | 42,343.64 | 2,218.60 | |
| Average gross profit for calendar years | ||||
| 1936 to 1939, incl | 58.63 | 10,585.91 | 554.65 | |
| 1940 | ||||
| Sales | 1,669.00 | 374,634.53 | 2,404.59 | |
| Cost of sales | 973.14 | 254,174.20 | 1,170.94 | |
| Gross profit | 695.86 | 120,460.33 | 1,233.65 |
| (8) | (9) | ||
| Calendar Year | Total of | Job work | |
| (6) and (7) | |||
| 1936 | |||
| Sales | $ 31,473.67 | $ 77,026.27 | |
| Cost of sales | 20,945.07 | 55,116.26 | |
| Gross profit | 10,528.60 | 21,910.01 | |
| 1937 | |||
| Sales | 51,617.58 | 157,735.13 | |
| Cost of sales | 35,215.42 | 104,239.97 | |
| Gross profit | 16,402.16 | 53,495.16 | |
| 1938 | |||
| Sales | 12,668.42 | 41,962.59 | |
| Cost of sales | 7,837.55 | 31,818.40 | |
| Gross profit | 4,830.87 | 10,144.19 | |
| 1939 | |||
| Sales | 59,478.87 | 89,180.98 | |
| Cost of sales | 46,678.26 | 68,538.71 | |
| Gross profit | 12,800.61 | 20,642.27 | |
| Totals for the 4 years | 44,562.24 | 106,191.63 | |
| Average gross profit for calendar years | |||
| 1936 to 1939, incl | 11,140.56 | 26,547.91 | |
| 1940 | |||
| Sales | 377,039.12 | 47,830.89 | |
| Cost of sales | 255,345.14 | 31,981.58 | |
| Gross profit | 121,693.98 | 15,849.31 |
During the years 1936 to 1940, inclusive, in addition to manufacturing milling machines and their accessories and parts, the petitioner from time to time engaged in doing some outside contract machine work, heretofore referred to as job work. The job work consisted of producing parts for other companies' products, repairing and maintaining other companies' tools and machinery, and building special machines for*266 assembling, packaging, or performing other operations for other companies' consumer products. Such special machines were usually built according to plans and specifications furnished by the other companies. None of the machines was a machine tool.
Expenditures made by the petitioner during the years 1936 to 1940, inclusive, in developing its new Knight milling machines, and the percentages of the total of such expenditures applicable to each of such years, are shown in the following list: *522
| (1) | (2) | (3) | (4) | (5) | (6) | |
| Development | ||||||
| Calendar year | and | Tools | Salaries | Pattern | Total | Percent |
| experimental | allocated | expense | of total | |||
| work | ||||||
| 1936 | $ 5,961.26 | $ 60.32 | $ 5,278.47 | $ 16.00 | $ 11,316.05 | 19.00 |
| 1937 | 3,344.18 | 2,195.77 | 4,995.01 | 475.77 | 11,010.73 | 18.49 |
| 1938 | 185.83 | 1,256.20 | 5,393.30 | 231.31 | 7,066.64 | 11.86 |
| 1939 | 4,871.73 | 1,116.10 | 2,303.29 | 557.07 | 8,848.19 | 14.86 |
| 1940 | 3,283.35 | 11,341.69 | 2,410.44 | 4,281.82 | 21,317.30 | 35.79 |
| Total | 17,646.35 | 15,970.08 | 20,380.51 | 5,561.97 | 59,558.91 | 100.00 |
The figures shown in columns 1, 2, and 4 are taken from the petitioner's books of account. The figures shown in column 3 are*267 not charged to the development of the new Knight milling machines on the petitioner's books, but are considered reasonable allocations of the salaries of its president and superintendent to such work.
The petitioner is a member of the National Machine Tool Builders' Association. That association compiles statistics on the sales of machine tools and is the only available source for determining the sales of machine tools manufactured in the United States. The association gathered the statistics upon the sales of machine tools and attachments and accessories for such tools manufactured and sold in the United States during the years 1936, 1937, 1938, 1939, and 1940 from reports on actual shipments thereof from machine tool manufacturers representing 85 percent of the machine tool manufacturing industry. Those statistics show that such sales (which include the sales made of machine tools and attachments and accessories used in connection therewith manufactured by petitioner) for the years 1936, 1937, 1938, 1939, and 1940 are as follows:
| 1936 | $ 133,000,000 |
| 1937 | 195,000,000 |
| 1938 | 145,000,000 |
| 1939 | 200,000,000 |
| Total | 673,000,000 |
| Average | 168,250,000 |
| 1940 | 440,000,000 |
*268 Improvement in business conditions and growth in the volume of sales for 1940 over the period 1936 to 1939, inclusive, is represented by the factor 2.652, determined by dividing $ 440,000,000 by $ 168,250,000.
In the event this Court finds that any of the net abnormal income is attributable to any year prior to 1940, it was stipulated that such abnormal income should be computed as set forth in one of the following four paragraphs or in any other manner that this Court may decide.
*523 If the figures in column (1) of the table heretofore set forth are to be used in determining abnormal income, then the net abnormal income for 1940 to be allocated to the years 1936 to 1940, inclusive, according to the percentages shown in column (6) of the expenditures list, is $ 11,130.83, computed as follows:
| (a) Gross profit for the year 1940 from column (1) | $ 137,543.29 | ||
| (b) Deduct: | |||
| 125% of the average gross profit of this class for the | |||
| four calendar years 1936 to 1939, inclusive, multiplied | |||
| by the factor 2.6152, to allow for improvement in | |||
| business conditions and growth of business volume | |||
| (1.25 x 37,688.47 x 2.6152) | 123,203.61 | ||
| Excess of (a) over (b) | 14,339.68 | ||
| Deduct: | |||
| Direct costs and expenses remaining after deducting from | |||
| total costs and expenses those costs and expenses which were | |||
| allocated to cost of sales on petitioner's cost records, | |||
| $ 30,780.32, allocated in the same ratio as $ 14,339.68 | |||
| bears to $ 137,543.29 = 10.425% of $ 30,780.32 | 3,208.85 | ||
| Net abnormal income | 11,130.83 |
*269 If the figures in column (3) of the table are to be used in determining abnormal income, then the net abnormal income for 1940 to be allocated to the years 1936 to 1940, inclusive, according to the percentages shown in column (6) of the expenditures list, is $ 66,081.73, computed as follows:
| (a) Gross profit for year 1940 from column (3) | $ 97,590.30 | ||
| (b)Deduct: | |||
| 125% of the average gross profit of this class for the | |||
| calendar years 1936 to 1939, inclusive, multiplied by | |||
| the factor 2.6152, to allow for improvement in business | |||
| conditions and normal growth of business volume | |||
| (1.25 x 3,810.61 x 2.6152) | 12,456.88 | ||
| Excess of (a) over (b) | 85,133.42 | ||
| Deduct: | |||
| Direct costs and expenses remaining after deducting from | |||
| total costs and expenses those costs and expenses which were | |||
| allocated to cost of sales on petitioner's cost record, | |||
| $ 30,780.32, allocated in the same ratio as $ 97,590.30 bears | |||
| to $ 137,543.29, that is, $ 21,839.38, which latter amount is | |||
| further allocated in the same ratio as $ 85,133.42 bears to | |||
| $ 97,590.30 | 19,051.69 | ||
| Net abnormal income | 66,081.73 |
If the figures in column (6) of the table are to be used in determining abnormal*270 income, then the net abnormal income for 1940 to be allocated to the years 1936 to 1940, inclusive, according to the percentages shown in column (6) of the expenditures list, is $ 66,641.81, computed as follows: *524
| (a) Gross profits for year 1940 from column (6) | $ 120,460.33 | ||
| (b) Deduct: | |||
| 125% of the average gross profit of this class for the | |||
| four calendar years 1936 to 1939, inclusive, multiplied | |||
| by the factor 2.6152, to allow for improvement in | |||
| business conditions and normal growth of business | |||
| volume (1.25 x 10,585.91 x 2.6152) | 34,605.35 | ||
| Excess of (a) over (b) | 85,854.98 | ||
| Deduct: | |||
| Direct costs and expenses remaining after deducting from | |||
| total costs and expenses those costs and expenses which were | |||
| allocated to cost of sales on petitioner's cost records, | |||
| $ 30,780.32, allocated in the same ratio as $ 120,460.33 | |||
| bears to $ 137,543.29, that is $ 26,957.38, which latter | |||
| amount is further allocated in the same ratio as $ 85,854.98 | |||
| bears to $ 120,460.33 | 19,213.17 | ||
| Net abnormal income | 66,641.81 |
If the figures in column (8) of the table are to be used in determining abnormal income, then the net abnormal income for 1940 to be allocated*271 to the years 1936 to 1940, inclusive, according to the percentages shown in column (6) of the expenditures list, is $ 66,192, computed as follows:
| (a) Gross profit for year 1940 from column (8) | $ 121,693.98 | ||
| (b) Deduct: | |||
| 125% of the average gross profit of this class for | |||
| the four calendar years 1936 to 1939, inclusive, | |||
| multiplied by the factor 2.6152, to allow for | |||
| improvement in business conditions and normal growth of | |||
| business volume (1.25 x 11,140.56 x 2.6152) | 36,418.49 | ||
| Excess of (a) over (b) | 85,275.49 | ||
| Deduct: | |||
| Direct costs and expenses remaining after deducting from | |||
| total costs and expenses those costs and expenses which were | |||
| allocated to cost of sales on petitioner's cost records, | |||
| $ 30,780.32, allocated in the same ratio as $ 121,693.98 | |||
| bears to $ 137,543.29, that is $ 27,233.46, which latter | |||
| amount is further allocated in the same ratio as $ 85,275.49 | |||
| bears to $ 121,693.98 | 19,083.49 | ||
| Net abnormal income | 66,192.00 |
No experimental or development work was done on the attachments for Knight milling machines sold during the period 1936 to 1939, inclusive. Such attachments are sold and billed separately from milling machines.
The*272 petitioner's plant capacity was not materially increased during the period 1936 to 1940, inclusive. During each of those years, the petitioner rented the same land and building facilities and paid the same rental therefor, $ 9,000 a year. The petitioner's balance sheets *525 appearing in its Federal income tax returns for the years 1936 to 1940, inclusive, are incorporated herein by reference. No part of the net abnormal income of the petitioner is due to decrease in operating costs. The petitioner paid the United States $ 13,437.43 as excess profits tax for the year 1940.
Knight millers Nos. 1, 1 1/2, 2-B, 3-B, and 4 were manufactured and sold over various periods of time. The first machine was built in 1906 and the last in 1935. Some of the machines were sold during the period from 1936 to 1940, inclusive. Knight millers Nos. 20, 30, and 40 were manufactured and sold subsequent to 1936.
The record discloses the following additional facts:
The petitioner first manufactured a milling and drilling machine in 1906. It was called No. 1. No. 1 1/2 was built in 1910 and No. 2-B in 1929 and 1930. Very few of the No. 2-B models were made. No. 3-B was produced during the period*273 prior to 1935 and No. 4 was last constructed in 1931. The total output of No. 3-B and No. 4 was 37 and 60, respectively. The prices of those machines ranged from $ 450 for No. 1 to $ 2,950 for No. 4.
The years of last manufacture and the sales during the period from 1936 to 1940, inclusive, were as follows:
| Year last sold | ||||||
| No. | Year last manufactured | |||||
| 1936 | 1937 | 1938 | 1939 | 1940 | ||
| 1 | 1928 (1) | 0 | 1 | 1 | 1 | 0 |
| 1 1/2 | 1929 | 1 | 3 | 2 | 2 | 2 |
| 2-B | 1930 | 1 | 4 | 1 | 0 | 1 |
| 3-B | 1935 | 3 | 5 | 1 | 0 | 0 |
| 4 | 1931 | 6 | 0 | 0 | 0 | 0 |
Prior to 1936 the petitioner's sales had decreased materially. Through its salesmen it had learned that its competitors were installing new features on their milling machines. In October 1935 the National Machine Tool Builders' Association held at Cleveland, Ohio, an exhibit at which such rival machines were shown. The petitioner then became convinced that its present machines were outmoded and that it must build an entirely new line of machines if it wanted to stay in business.
Thereupon the petitioner's president, plant manager, and factory superintendent, aided by suggestions from its salesmen, proceeded to create, design, and build an experimental machine, *274 called No. 40, which was completed during the latter part of 1936. The ideas incorporated therein were solely those of the petitioner's officers and were calculated to produce a machine new and different from those of its competitors, as well as from its own No. 1 to No. 4 series. The competitors' machines shown at the exhibit were largely specialized or designed particularly to perform a specific function or type of operation.
*526 The petitioner's purpose was to build a "universal" or balanced machine, capable of producing a wider variety of work with a maximum amount of power, speed, accuracy, and versatility. Such a machine was a drastic and radical departure in design, operation, and efficiency from its machines theretofore manufactured. The production of the latter was discontinued in 1935. The petitioner's patents on its old and obsolete machines had expired. It did not seek patents on the new designs, because such machines can be "designed around" without infringement and also because a small company such as the petitioner has difficulty in defending its patents.
The petitioner built machine No. 40 in its own shop. It followed the usual procedure of preparing drawings, *275 checking the various elements against each other, making patterns, and casting the parts in accordance therewith, and revising, correcting, and perfecting the articulation, correlation, and synchronization of the parts into an efficient and smooth-running machine. The petitioner sold its first No. 40 in 1937. It then produced No. 30, a size smaller than No. 40. Six No. 30 machines were sold in 1938. Both No. 40 and No. 30 machines were considered experimental. While they were being used by customers they were observed, tested, serviced, and checked for performance and possible defects. Later the petitioner produced No. 20, a size still smaller than No. 30.
The petitioner attempted to perfect the machines by October 1939, when another National Machine Tool Builders' Association exhibit was scheduled to be held. However, the war prevented the exhibit and sales promotion was started by another method. The petitioner considered the new machines commercially successful in 1940.
The line of demarcation between the construction and functions of the old machines and the Knight millers (new type) was sharply and clearly drawn. The old machines were drilling machines, while the new*276 were milling and jig boring. Both types also performed shaping and slotting operations, but the new machines were more efficient. In the new product the functions of the old machines were not only enlarged, but new ones were incorporated. The prices of the new machines were fixed at $ 5,170, $ 4,290, and $ 3,520 for Nos. 40, 30, and 20, respectively. These prices were frozen by the Government in May 1940.
The percentages of the sales of the petitioner's machine tools to those sold by the industry as a whole, are as follows:
| 1936 | .021 |
| 1937 | .024 |
| 1938 | .006 |
| 1939 | .028 |
| 1940 | .084 |
The petitioner considered that the proportionate increase in its sales in 1940 was due to the demand for the new machines and their acceptance and successful use by the consumers in the industry.
*527 The specific differences between old and new machines are necessarily couched in highly technical terms. In more common language, they may be summarized as follows:
The new machines were larger and heavier than the old. They had a speed of 2,000 revolutions per minute, as against 385 revolutions per minute of the old type. Better and different material was demanded by the new product. The*277 old had about 300 parts. Between 400 and 450 principal parts were required in the new No. 40 and all had to be designed. About 25 or 30 standard parts, such as hand wheels, bolts, nuts, oil caps, etc., were also used in its construction.
The principal factors in an efficient milling machine are accuracy, rigidity, versatility, balance, power, speed, smoothness, and productive capacity. In all of these features the performance of the old machines was far from the standard required to meet competition and to assure the petitioner of a merchantable product. To secure the desired improvement in the quality of work done by the machines and to widen the scope of their functions, many innovations were adopted in the manufacture of the new models. Chief among these were the following:
1. New gears of heat-treated steel with proper tooth formation and new tooth finishing, instead of the old cast iron material.
2. A new method of gear shifting.
3. A high speed spindle.
4. A new type of bearings.
5. A new lubrication system.
6. The installation of brakes.
7. A new type of clutch.
8. The addition of a safety release.
9. Alignment control.
10. The substitution of hand feed for worm feed*278 and the improvement of power feed mechanism.
11. A new spindle head clamp.
12. Constant speed motor drive, with multiple V-belts instead of a line shifting belt.
13. A built-in motor unit.
14. New gear boxes to provide for six spindle speed changes instead of eight, as on the old machine.
15. A new table unit with new tilting mechanism.
Only very minor changes were made in the old machines from 1906 to 1935. No changes have been made in models Nos. 40, 30, and 20, except those in material necessitated by war conditions. Between 1938 and 1940 labor costs increased.
The development expenses of the new machines were entered on the petitioner's books as expenses and were not capitalized. The cost of the experimental model No. 40, built in 1936, was first carried as expense and then it was put into factory equipment and was capitalized *528 at the estimated manufacturing cost. All remaining experimental and development expenditures were carried as expense.
The petitioner does job work for other concerns according to their specifications and usually from material furnished by them. When the petitioner was manufacturing Knight millers it also did job work which is carried on *279 shop records. The petitioner's office had nothing to do with such work. The cost of manufacturing new machines, later sold, was charged against the sales thereof and was not included in the cost of development, as heretofore set forth.
In its return for 1940 the petitioner excluded from income $ 10,315.23 representing abnormal income. In his notice of deficiency the Commissioner added that amount to the petitioner's income with the explanation that "the evidence submitted does not bring your case within the scope of section 721 of the Internal Revenue Code."
OPINION.
The single issue is whether or not the petitioner is entitled to relief under the provisions of section 721, Internal Revenue Code. 1
*280 *529 The petitioner contends that its income derived in 1940 from the sale of Nos. 20, 30, and 40 Knight milling machines should be decreased by excluding therefrom the portion of the net abnormal income attributable to the period from 1936 to 1939, inclusive, by reason of the expenses incurred and disbursed in the "development of tangible property" (namely, the machines) during that period. The respondent asserts that the section is not applicable.
The history of section 721 is elaborately set forth and discussed in Premier Products Co., 2 T. C. 445, and W. B. Davis & Son, Inc., 5 T. C. 1195, and will not be repeated here. Its purpose is to afford relief to taxpayers who receive income from various sources which is inherently abnormal in character or in amount. The statute specifically establishes six classes of such income, but also includes any income not precisely within these categories, subject, however, to regulations prescribed by the Commissioner with the approval of the Secretary.
In the case at bar the petitioner claims, and the respondent agrees, that relief, if any, should be granted under subsection*281 (a) (2) (C). There is no controversy as to the character of the income. The petitioner's primary business is the manufacture of milling machines. It also does job work and makes spare parts as incidental activities. Likewise, there is no disagreement as to the amount of income derived from the sale of the new Nos. 20, 30, and 40 Knight millers, nor as to the amount of development expenditures allocable to each of the years in the critical period. Such expenditures made in the taxable year are not taken into consideration in the computation relating to the period from 1936 to 1939, inclusive.
The respondent challenges the application of the statute on the sole ground that the expenditures denominated by the petitioner "development expenses" were not such expenses within the meaning of the statute. He claims the petitioner did not develop a new milling machine, *530 but merely perfected and produced new models of its machines already established on the market and sold to the trade. He contends that these are but the normal problems and processes which all manufacturers must meet and provide for periodically. He cites and relies on section 30.721-3 of Regulations 109, as*282 amended, 2 and asserts that "in the light of the events in which such items had their origin" (i.e., the controverted items before us) they are not attributable to prior years but only represent the usual expenses incident to the improvement of the petitioner's product.
*283 Thus the issue is narrowed to the single question: Was the work of creating, designing, experimenting with, and testing the milling machine which ultimately became the No. 40 Knight miller a routine activity, customarily required in the conduct of the petitioner's business and consistent with its previous business experience, or did it constitute a radical departure from the art and methods of manufacture employed by the petitioner theretofore and thus produce a new and different machine having little relation to the old product?
The facts as stipulated and adduced at the hearing demonstrate that the new No. 20, No. 30, and No. 40 Knight millers were new machines which were created, designed, and perfected to do work, both in *531 kind and extent, which the old machines could not perform. The old type of machine was manufactured first in 1906. From that year until 1935 the No. 1 machine and its successors had been made and sold with only minor changes in construction. In 1935 the petitioner's officers became convinced that those machines could no longer serve their purpose in competition with others on the market and that they were rapidly becoming obsolete. They knew that*284 drastic measures must be taken to keep the petitioner in business and consequently they undertook to design and construct a machine that would be much more efficient than the old type and would be capable of performing more kinds of operations. In short, it must meet the increasingly exacting demands of the trade.
The activities and work done by the petitioner, through its officers, from 1936 to 1940 resulted in the construction of Knight miller No. 40. We have set forth in the facts the fifteen or more innovations which were incorporated therein. Some were wholly new. These features were successfully assembled in one harmoniously effective machine which bore only superficial resemblance to the last of the old line of millers prior to 1936. Of course, the principal business of the petitioner remained the same, producing milling machines, and the functions of those machines were somewhat similar both in the new and old types, but the expenditures in question were made for the purpose of creating, for the old type, a substitute which in itself was entirely new and essentially different from its predecessor. This it was able to do.
Since placing it on the market, the petitioner*285 has made no changes in No. 40 or in its smaller counterparts Nos. 30 and 20, except such substitutions of materials as were necessitated by war conditions. The petitioner deemed it commercially successful in 1940. The facts in the case before us bring it within the broad scope of section 721 (a) (2) (C) and the petitioner is entitled to compute its income as provided in section 721 (c).
The record shows the proper amounts of expenditures allocable to prior years. The parties have stipulated that the factor 2.6152 represents the improvement in business conditions and the growth in the volume of sales for 1940 over the period of 1936 to 1939, inclusive, as contemplated in section 30.721-3, Regulations 109, as amended, and have recognized and used that factor in their proposed computations of net abnormal income, as set forth in the facts. They differ, however, on the proper basis of such computation. The respondent contends that the entire gross profit derived by the petitioner from all operations in 1940 should be the basis of the computation, while the petitioner insists that the gross profit basis should be restricted to that derived from the sale of models Nos. 20, 30, and *286 40.
The petitioner's operations were classified in the findings of fact under the heads of old style Knight milling machines; attachments *532 for Knight milling machines; purchased attachments; repair parts; job work; and model Nos. 20, 30, and 40 Knight milling machines. In the stipulation, all "expenditures made by the petitioner during the years 1936 to 1940 inclusive, in developing its new Knight Milling Machines" are segregated. The class of income to which the expenditures related is thus defined and established. Expenditures applicable to the petitioner's other operations were charged to such operations. No "development" or other expenses specified in the statute relating to such other operations were incurred or made, nor were they included in the stipulated figures. Thus we have a proper foundation for computing the tax with relation to the class of income specifically provided for by the statute and attributable to other taxable years.
The respondent argues that the petitioner was engaged in only a single activity, "manufacturing," and that no provision has been made in the regulations for the division of income therefrom into classes of income derived from the*287 manufacture of each individual product. He cites the regulations (sec. 30.721-8, Regulations 109, as amended) 3 in support of his argument and observes that "any material sales in 1940 of the model numbers 20, 30, and 40 milling machines would of necessity be many times the sales of those machines in the base period for the reason that those particular models were not being sold in the base period, although other milling machines of a like or similar construction and serving the same purpose were being manufactured and sold in such base period."
*288 The respondent's position is consonant with his theory that the production of the new machines was but a process of improving the old machines. So far as this case is concerned, we have discarded that theory. Furthermore, we believe that the statute means just what it says -- that any income of the type or class specified in subsection (a) (2) of section 721 is to be recognized in applying the relief measures which the statute grants.
The generic term "manufacture" might cover many separate and wholly distinct activities or operations. In this case only the income which arises from the "exploration, discovery, prospecting, research or development of tangible property, patents, formulae, or processes, or any combination of them extending over a period of 12 months" occasions the application of the statute. The statute deals with the *533 source of the income, not the character of the taxpayer's activities, whether they be single or multiple. The property of the petitioner was developed in order to enable it to carry on its business. The abnormal income was derived from the sale of that property.
Therefore, restricting the application of section 721 to the income resulting*289 from the development of the new Knight millers, our task is to determine, first, petitioner's net abnormal income as that term is defined in section 721 (a) (3).
The parties have stipulated four different methods of the computation to be used in determining petitioner's net abnormal income for the year 1940, depending upon the factor of gross income that is to be used as a starting basis. They also agree that this Court may, of course, choose its own method of computation. On consideration, we find ourselves in agreement with none of the stipulated methods.
It is manifest from what we have said above that it is our view that the gross profit for the year 1940 from column (3) should be used as a starting point. This figure is $ 97,590.30. However, we can not agree that the computation which has been made by using the gross income in column (3) is correctly made. It seems clear to us that it does not follow the statute. In the computation the following appears: 1.25X$ 3,810.61X2.6152=$ 12,456.88, and the latter figure is deducted from the gross profit for 1940. We find no statutory warrant for thus using the figure 2.6152 in that connection. Those figures are very vital in making*290 the final determination as to what part of the net abnormal income is to be attributable to other years, as we shall presently discuss, but they have no place in the computation of the net abnormal income itself. The statute prescribes how the net abnormal income is to be computed. Section 721 (a) (3), supra, provides that it shall be determined by subtracting from the amount of the abnormal income "(A) 125 per centum of the average amount of the gross income of the same class determined under paragraph (1), and (B) an amount which bears the same ratio to the amount of any direct costs or expenses, deductible in determining the normal-tax net income of the taxable year, through the expenditure of which such abnormal income was in whole or in part derived as the excess of the amount of such abnormal income over 125 per centum of such average amount bears to the amount of such abnormal income." Therefore, starting with column (3) as the base (for reasons which we have already stated), the computation under section 721 (a) (3) is as follows:
| (a) Gross profit for year 1940 from column (3) | $ 97,590.30 | |
| (b) Deduct under section 721 (a) (3) (A): | ||
| 125% of $ 3,810.61 from column (3) | 4,763.26 | |
| Excess of (a) over (b) | 92,827.04 | |
| (c) Deduct under section 721 (a) (3) (B): | ||
| Direct costs and expenses remaining after deducting from | ||
| total costs and expenses those costs and expenses which | ||
| were allocated to cost of sales on petitioner's cost | ||
| record, $ 30,780.32, allocated in the same ratio as | ||
| $ 97,590.30 bears to $ 137,543.29, that is, $ 21,839.38, | ||
| which latter amount is further allocated in the same ratio | ||
| as $ 92,827.04 bears to $ 97,590.30 | $ 20,773.43 | |
| Net abnormal income | 72,053.61 |
*291 *534 Thus we find that petitioner's net abnormal income for 1940 is $ 72,053.61.
But the mere fact that a taxpayer has net abnormal income in a taxable year does not entitle it to relief under section 721. There must be a further finding under the evidence as to what part, if any, of such net abnormal income is attributable to other years. If none is so attributable, then the taxpayer gets no relief. See our discussion on this point in Premier Products Co., supra.Therefore, we must, under the evidence, determine what portion, if any, of petitioner's $ 72,053.61 net abnormal income is attributable to other years.
First, we know that no part of such income can be so attributed which was due solely to improvement in business conditions. Section 30.721-3 of the Regulations provides, among other things:
* * * Thus, no portion of an item is to be attributed to other years if such item is of a class of income which is in excess of 125 per cent of the average income of the same class for the four previous taxable years solely because of an improvement in business conditions.
The parties are in agreement that: "Improvement in business conditions *292 and growth in the volume of sales for 1940 over the period 1936 to 1939, inclusive, is represented by the factor 2.6152." Therefore, applying this factor to petitioner's net abnormal income of $ 72,053.61, we find that $ 44,501.76 was due to improved business conditions and none of it can be attributed to prior years under the applicable statute and regulations. This leaves $ 27,551.85 of petitioner's net abnormal income which was not due to improved business conditions and which, we think, may fairly be attributed to the expenditures which petitioner made during the period 1936 to 1940 in bringing its machines Nos. 20, 30, and 40 to commercial production. These expenditures are shown in detail for the years 1936-1940, inclusive, in our findings of fact. The percentages for each year are shown. From these percentages it seems clear that 35.79 percent of the $ 27,551.85 above mentioned must be attributed to 1940 and the balance of the $ 27,551.85 is to be attributed to the prior years 1936, 1937, 1938, and 1939, in accordance with the percentages set opposite the respective years in our findings of fact. The parties seem to be agreed that whatever net abnormal *535 income *293 we find is to be attributed to other years should be allocated in accordance with the percentages shown in our findings of fact. Section 30.721-3 of the Commissioner's regulations says in part:
Items of net abnormal income are to be attributed to other years in the light of the events in which such items had their origin, and only in such amounts as are reasonable in the light of such events.
Under the facts of the instant case, we think the allocation by these percentages meets the test of the foregoing regulations and we direct that it be used. Cf. W. B. Davis & Sons, Inc., 5 T. C. 1195.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.
(a) Definitions. -- For the purposes of this section --
(1) Abnormal income. -- The term "abnormal income" means income of any class includible in the gross income of the taxpayer for any taxable year under this subchapter if it is abnormal for the taxpayer to derive income of such class, or, if the taxpayer normally derives income of such class but the amount of such income of such class includible in the gross income of the taxable year is in excess of 125 per centum of the average amount of the gross income of the same class for the four previous taxable years, * * *
(2) Separate classes of income. -- Each of the following subparagraphs shall be held to describe a separate class of income:
(A) Income arising out of a claim, award, judgment, or decree, or interest on any of the foregoing; or
(B) Income constituting an amount payable under a contract the performance of which required more than 12 months; or
(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
(D) Income includible in gross income for the taxable year rather than for a different taxable year by reason of a change in the taxpayer's accounting period or method of accounting; or
(E) In the case of a lessor of real property, income included in gross income for the taxable year by reason of the termination of the lease; or
(F) Income consisting of dividends on stock of foreign corporations, except foreign personal holding companies.
All the income which is classifiable in more than one of such subparagraphs shall be classified under the one which the taxpayer irrevocably elects. The classification of income of any class not described in subparagraphs (A) to (F), inclusive, shall be subject to regulations prescribed by the Commissioner with the approval of the Secretary.(3) Net abnormal income. -- The term "net abnormal income" means the amount of the abnormal income less, under regulations prescribed by the Commissioner with the approval of the Secretary, (A) 125 per centum of the average amount of the gross income of the same class determined under paragraph (1), and (B) an amount which bears the same ratio to the amount of any direct costs or expenses, deductible in determining the normal-tax net income of the taxable year, through the expenditure of which such abnormal income was in whole or in part derived as the excess of the amount of such abnormal income over 125 per centum of such average amount bears to the amount of such abnormal income.
(b) Amount Attributable to Other Years. -- The amount of the net abnormal income that is attributable to any previous or future taxable year or years shall be determined under regulations prescribed by the Commissioner with the approval of the Secretary. * * *
(c) Computation of Tax for Current Taxable Year. -- The tax under this subchapter for the taxable year, in which the whole of such abnormal income would without regard to this section be includible, shall not exceed the sum of:
(1) The tax under this subchapter for such taxable year computed without the inclusion in gross income of the portion of the net abnormal income which is attributable to any other taxable year, and
(2) the aggregate of the increase in the tax under this subchapter for the taxable year (computed under paragraph (1)) and for each previous taxable year which would have resulted if, for each previous taxable year to which any portion of such net abnormal income is attributable, an amount equal to such portion had been included in the gross income for such previous taxable year.
(d) Computation of Tax for Future Taxable Year. -- The amount of the net abnormal income attributable to any future taxable year shall, for the purposes of this subchapter, be included in the gross income for such taxable year. * * *
(e) Application of Section. -- This section shall be applied only for the purpose of computing the tax under this subchapter as provided in subsections (c) and (d), and shall have no effect upon the computation of base period net income. * * *↩
2. Sec. 30.721-3. Amount attributable to other years. -- The mere fact that an item includible in gross income is of a class abnormal either in kind or in amount does not result in the exclusion of any part of such item from excess profits net income. It is necessary that the item be found attributable under these regulations in whole or in part to other taxable years. Only that portion of the item which is found to be attributable to other years may be excluded from the gross income of the taxpayer for the year for which the excess profits tax is being computed.
Items of net abnormal income are to be attributed to other years in the light of the events in which such items had their origin, and only in such amounts as are reasonable in the light of such events. To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer, such items shall not be attributed to other taxable years. Thus, no portion of an item is to be attributed to other years if such item is of a class of income which is in excess of 125 per cent of the average income of the same class for the four previous taxable years solely because of an improvement in business conditions. In attributing items of net abnormal income to other years, particular attention must be paid to changes in those years in the factors which determined the amount of such income, such as changes in prices, amount of production, and demand for the product. No portion of an item of net abnormal income is to be attributed to any previous year solely by reason of an investment by the taxpayer in assets, tangible or intangible, employed in or contributing to the production of such income.
* * * *
Specific methods of treating items of net abnormal income of the six classes specified in section 721 (a) are set forth in sections 30.721-6 to 30.721-11. These methods are to be applied subject to the provisions of this section.
* * * *
Sec. 30.721-8. Exploration, discovery, prospecting, research, or development. -- The third 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. Sec. 30.721-8. Exploration, discovery, prospecting, research, or development. -- * * *
An item of income resulting from exploration, discovery, prospecting, research, or development is all such income for the taxable year arising out of a unit of property such as an oil lease or other mineral property defined in section 19.23(m)-1(i↩), a patent, or a formula. If the taxpayer engages in manufacturing, marketing, mining, oil production, or similar activities, only such portion of the resulting income as is attributable to exploration, discovery, prospecting, research, or development is within the class of income described in this section. * * *