General Tire & Rubber Co. v. Commissioner

General Tire & Rubber Company, Petitioner, v. Commissioner of Internal Revenue, Respondent General Tire & Rubber Co. v. Commissioner Docket No. 51537 United States Tax Court 29 T.C. 975; 1958 U.S. Tax Ct. LEXIS 248; February 27, 1958, Filed *248 Decision will be entered under Rule 50. Petitioner, a manufacturer of coated fabrics, engaged in a program of research resulting in the development of a resin coating known as Tolex. Held, a portion of the income resulting from the sale of Tolex constitutes net abnormal income resulting from research and development within the meaning of section 721 (a) (2) (C), I. R. C. 1939, and is allocable to the years during which the research and development program was in operation, pursuant to section 721 (b), I. R. C. 1939. Richard W. Wilson, Esq., and Gustave Simons, Esq., for the petitioner. Robert E. Johnson, Esq., for the respondent. Withey, Judge. WITHEY *975 The respondent denied taxpayer's claims for refund of excess profits taxes under section 721 of the Internal Revenue Code of 1939 for the years 1942*249 through 1945. The sole issue presented for our decision is the question whether taxpayer derived net abnormal income of a class specified by section 721 (a) (2) (C) of the 1939 Code during 1942, 1943, 1944, and 1945, attributable to prior years so as to entitle taxpayer to the relief accorded by that section. The petition herein was filed by the Textileather Corporation. Subsequent to the filing of the petition and answer, Textileather Corporation was merged with the General Tire & Rubber Company. Consequently, upon motion for substitution made at the trial, the caption of the proceeding was changed to indicate the substitution of General Tire & Rubber Company as petitioner. FINDINGS OF FACT. Some of the facts have been stipulated and are found accordingly. Textileather (sometimes hereinafter referred to as taxpayer) is a corporation organized under the laws of the State of Delaware in 1927 with its principal place of business located at Toledo, Ohio. It filed its corporation income and declared value excess-profits tax returns and excess profits tax returns for 1942, 1943, 1944, and 1945 with the collector of internal revenue for the tenth district of Ohio. Taxpayer filed claims*250 for refund under section 721 of the 1939 Code for the years and in the amounts as follows: Year Amount of claim [1942] $ 39,119.01 [1943] 365,408.09 [1944] 380,523.66 [1945] 156,629.87 *976 Amended claims for refund under section 721 were filed by Textileather for the years and in the amounts as follows: Year Amount of claim [1942] $ 14,274.96 [1943] 56,983.99 [1944] 102,128.99 The foregoing claims and amended claims were disallowed in full by the respondent. The taxpayer here contends that its net abnormal income due to research and development and attributable to prior years is $ 25,498.55 for 1942, $ 585,145.16 for 1943, $ 568,913.81 for 1944, and $ 261,989.13 for 1945. Beginning in 1927, Textileather was engaged in the manufacture and sale of rubber-coated fabrics and pyroxylin-coated fabrics, and in the dyeing and finishing of cotton cloth. It did not manufacture finished products, i. e., luggage upholstery, etc., but only coated fabrics, the end uses of which were in competition with leather. Textileather abandoned its rubber department in 1936 or 1937, but added duck impregnation and vinyl-coated fabrics during the period 1942 to 1945. During the 1920's a *251 strong demand arose, originating principally in the automotive, furniture, and luggage industries, for a new and different product superior to the then known pyroxylin-coated materials. Pyroxylin is a nitrocellulose compound which when pigmented and plasticized into a semifluid form can be spread by a coater. The uses of pyroxylin are restricted because of its resistance to flexing, stretching, and folding, its tendency to crack at low temperatures, its unsatisfactory resistance to abrasion, and its high degree of inflammability. In 1930, Textileather moved its operations from Newark, New Jersey, to Toledo, Ohio, where a new plant was built which was equipped with a research laboratory. Beginning in 1931, taxpayer began an intensive program of research and development for the purpose of creating and perfecting a new and different product that would meet the needs and demands of industry for a leatherlike material without the inherent weaknesses of pyroxylin which could be used in the numerous fields to which pyroxylin-coated fabrics were unsuited. The foregoing program of research, exploration, and development was conducted without interruption until the end of 1940. Additional*252 impetus was given the research and development work in 1932 and 1933 by the adoption of fixed specifications by certain members of the automotive industry, including Chrysler Corporation, Ford Motor Company, and Fisher Bodies, requiring a degree of endurance not then found in any existing product. *977 The research and experimental work conducted by Textileather included the testing of certain types of resins, such as alkyd resins and resyl resins, but none was found adequate for the purpose. In 1938 or 1939, Bakelite Corporation, a division of Union Carbide and Carbon Corporation, developed and began the commercial production of a high molecular weight vinyl resin. This was a new product, previously unobtainable, and proved to be a satisfactory base for the material petitioner was seeking to produce. With the vinyl resin as a base, it was then necessary to develop the remaining constituents of the desired compound, i. e., the plasticizers, lubricants, stabilizers, and pigments, that could be combined with the resin base to develop a coating which was resistant to all kinds of weather and to many different chemicals and that possessed many of the characteristics of leather. *253 By the end of 1940, a satisfactory product was developed which was thereafter named and registered "Tolex." The final testing of Tolex, in the form of trial runs, was done on equipment belonging to the National Carbon Company of Cleveland, Ohio, during the closing months of 1940 and January 1941. Tolex was an entirely new and unique product in the field of leatherlike, plastic-coated fabrics, possessing qualities far superior to the pyroxylin-coated materials then used, such as flexing, folding, and resistance to heat, fire, cold, and to various chemicals. In addition to its adaptability to end uses in products where leather, rubber, or pyroxylins were used, Tolex also proved adaptable to items for which leather, rubber, and pyroxylins could not be used. A low molecular weight vinyl resin was also produced by Union Carbide and Carbon Corporation, beginning in 1938. Low molecular weight vinyl resins are closely related to high molecular weight vinyl resins, and are produced for similar end uses. During World War II, low molecular weight vinyl resins were sometimes used as substitutes for high molecular weight vinyl resins. During the latter part of 1940, Textileather placed an*254 order with Farrell-Birmingham Company for machinery and equipment necessary to manufacture Tolex. Delivery thereon was delayed for more than a year. The actual commercial production of Tolex did not begin until May 1942. The research, experimental, and developmental expenses paid or incurred by the taxpayer in the development of Tolex for the years 1931 to 1940, inclusive, were as follows: Year Amount [1931] $ 11,993.85 [1932] 7,691.97 [1933] 5,321.78 [1934] 7,575.84 [1935] 7,203.11 [1936] 10,567.86 [1937] $ 13,615.31 [1938] 10,884.51 [1939] 19,915.29 [1940] 29,062.42 Total 123,831.94 *978 Although the development of Tolex was a peacetime project for the purpose of supplying various industries, including the automotive and luggage industries, with a normal commercial product, the United States had entered World War II shortly prior to the first production of Tolex and, consequently, during the years 1942 through 1945, the entire output of this product was utilized for military and defense purposes. During World War II, certain restrictions were imposed upon the production of Tolex. Because of the allocation of raw materials and the system of priority ratings then in effect, *255 the supply of resins, textiles, and other materials necessary for the production of Tolex was inadequate to meet the existing demand. Tolex was sold under price restrictions. During the years 1942, 1943, 1944, and 1945, taxpayer was the sole producer of Tolex and, during 1942 and 1943, it was without active competition in the production of marketable high molecular weight vinyl fabrics. During World War II, Tolex was utilized in the production of aircraft, tanks, life rafts, gun mount covers, surgical hospital sheeting, life jackets, bedding, navy bags, and numerous other military items. At the conclusion of World War II, no plant reconversion was necessary to enable Textileather to commence civilian production. However, certain new equipment was purchased in order to meet the normal industrial demand for different styling. Textileather operated at full capacity in the production of Tolex during the war years and has continued to operate at full capacity thereafter. The industrial demand for a product possessing the qualities of Tolex was felt at the close of World War II. Tolex was sold for use in the automotive, furniture, luggage, leather goods, shoe, upholstery, pharmaceutical, *256 bicycle, and saddle industries, as well as for use in the production of bookbinding, baby carriages, toys, garments, motion picture screens, and in theater and auditorium installations. Tolex did not supplant pyroxylins during World War II; however, in certain industries a substantial portion of pyroxylin purchases ultimately was replaced by purchases of Tolex. The sales of Tolex increased sharply and consistently after the removal of wartime restrictions, but it was not until 1948 that the inroads made upon pyroxylins by Tolex became clearly apparent. Taxpayer's net sales of pyroxylin and Tolex for the period 1947 to 1950, inclusive, were as follows: Year Pyroxylin net Tolex net sales sales [1947] $ 3,738,503 $ 4,888,976 [1948] 2,344,761 6,648,299 [1949] 2,126,360 8,003,749 [1950] 2,754,542 10,252,169 *979 In 1942 the taxpayer constructed a small building adjacent to its plant at a cost of $ 27,055.93 and purchased new machinery and equipment costing $ 93,256.95 in order to enable it to produce Tolex in sufficient quantities to meet the wartime demand. In addition to the foregoing assets, the undepreciated cost as of December 31, 1942, of taxpayer's buildings*257 ($ 774,924.48), machinery and equipment ($ 1,509,893.48), machinery in the process of installation ($ 8,541.03), and furniture and fixtures ($ 43,265.47) totaled the amount of $ 2,336,624.46. Textileather's net sales, gross profits, and net profits on Tolex for the years 1942 to 1945, inclusive, were as follows: Year Net sales Gross profit Net profit (5/1-12/31) 1942 $ 685,005.81 $ 57,080.02 $ 16,550.22 [1943] 3,152,645.95 709,741.12 543,246.31 [1944] 4,038,466.47 919,176.56 704,267.21 [1945] 3,519,665.18 843,347.44 599,301.17 The profit and loss statement of Textileather for each of the years 1942, 1943, 1944, and 1945 is as follows: *980 Profit and Loss Statement [1942] Total Finishing Corduroy Dept. Dept. Sales to customers $ 11,313,457.81 $ 1,033,934.54 $ 499,902.12 Returned goods (62,182.77) (46.41) Prepaid freight (28,841.91) (1,229.89) 11,222,433.13 1,032,658.24 499,902.12 Revenue from salvaged material 196,679.85 5,944.10 50,351.58 Revenue from sales of scrap 19,418.00 19,418.00 Net sales 11,438,530.98 1,058,020.34 550,253.70 Cost of sales 9,045,598.05 815,180.18 434,256.36 Cost variances 91,764.03 50,440.26 36,195.57 Reject and rework expense 309,693.62 13,233.72 47,030.98 Allowance for reject reworked (401,241.43) (57,868.92) (20,314.69) Solvent reclaimed (33,203.04) Net cost of sales 9,012,611.23 820,985.24 497,168.22 Gross profit from sales 2,425,919.75 237,035.10 53,085.48 Commercial expenses: Shipping expense 223,208.35 64,298.99 19,869.64 Selling expense 231,066.73 19,173.33 Administrative expense 213,243.04 30,400.36 19,191.88 667,518.12 113,872.68 39,061.52 Net profit 1,758,401.63 123,162.42 14,023.96 Other income 58,741.48 Other expenses (63,425.16) Net revenue 1,753,717.95 *258 Profit and Loss Statement [1942] Pyroxylin Rubber Tolex Dept. Dept. Dept. Sales to customers $ 8,893,338.65 $ 197,219.54 $ 689,062.96 Returned goods (59,183.95) (485.49) (2,466.92) Prepaid freight (25,512.68) (389.46) (1,709.88) 8,808,642.02 196,344.59 684,886.16 Revenue from salvaged material 140,177.89 86.63 119.65 Revenue from sales of scrap Net sales 8,948,819.91 196,431.22 685,005.81 Cost of sales 7,037,320.13 165,413.54 593,427.84 Cost variances (7,359.02) (5,722.01) 18,209.23 Reject and rework expense 204,872.30 44,556.62 Allowance for reject reworked (294,786.50) (3.42) (28,267.90) Solvent reclaimed (33,203.04) Net cost of sales 6,906,843.87 159,688.11 627,925.79 Gross profit from sales 2,041,976.04 36,743.11 57,080.02 Commercial expenses: Shipping expense 128,144.04 156.28 10,739.40 Selling expense 193,997.89 2,380.07 15,515.44 Administrative expense 142,978.55 6,397.29 14,274.96 465,120.48 8,933.64 40,529.80 Net profit 1,576,855.56 27,809.47 16,550.22 Other income Other expenses Net revenue *981 Profit and Loss Statement [1943] Total Finishing Corduroy Dept. Dept. Sales to customers $ 10,843,262.89 $ 1,037,640.53 $ 560,845.73 Returned goods (64,198.43) Prepaid freight (44,511.58) (1.13) 10,734,552.88 1,037,639.40 560,845.73 Revenue from salvaged material 256,352.19 19,440.24 46,757.47 Revenue from sales of scrap 10,790.16 10,790.16 Net sales 11,001,695.23 1,067,869.80 607,602.20 Cost of sales 8,838,219.10 857,491.34 491,738.71 Cost variances 232,143.95 203,999.64 83,255.91 Reject and rework expense 478,413.21 19,155.02 51,068.76 Allowance for reject reworked (370,814.43) (55,739.31) (22,865.54) Solvent reclaimed (71,682.19) Net cost of sales 9,106,279.64 1,024,906.69 603,179.84 Gross profit from sales 1,895,415.59 42,963.11 4,404.36 Commercial expenses: Shipping expense 236,171.78 71,628.11 22,701.72 Selling expense 293,520.48 13,141.36 Administrative expense 250,529.84 24,108.21 12,739.95 780,222.10 108,877.68 35,441.67 Net profit (or loss) 1,115,193.49 (65,914.57) (31,037.31) Other income 26,944.24 Other expense (64,835.29) Net revenue 1,077,302.44 *259 Profit and Loss Statement [1943] Pyroxylin Rubber Tolex Dept. Dept. Dept. Sales to customers $ 6,085,026.59 $ 50,805.68 $ 3,108,944.36 Returned goods (45,731.96) (18,466.47) Prepaid freight (33,719.29) (121.38) (10,669.78) 6,005,575.34 50,684.30 3,079,808.11 Revenue from salvaged material 117,317.64 72,837.84 Revenue from sales of scrap Net sales 6,122,892.98 50,684.30 3,152,645.95 Cost of sales 4,837,448.37 42,754.55 2,608,786.13 Cost variances 169,347.95 1,117.33 (225,576.88) Reject and rework expense 221,367.92 186,821.51 Allowance for reject reworked (165,083.65) (127,125.93) Solvent reclaimed (71,682.19) Net cost of sales 4,991,398.40 43,871.88 2,442,904.83 Gross profit from sales 1,131,494.58 6,812.42 709,741.12 Commercial expenses: Shipping expense 95,343.55 46,498.40 Selling expense 216,468.86 897.84 63,012.42 Administrative expense 154,404.68 2,293.01 56,983.99 466,217.09 3,190.85 166,494.81 Net profit (or loss) 665,277.49 3,621.57 543,246.31 Other income Other expense Net revenue *982 Profit and Loss Statement [1944] Total Finishing Corduroy Dept. Dept. Sales to customers $ 10,393,445.93 $ 820,841.35 $ 570,840.84 Returned goods (49,509.49) Prepaid freight (33,877.61) (5.71) 10,310,058.83 820,841.35 570,835.13 Revenue from salvaged material 203,717.73 46,092.92 50,268.47 Revenue from sales of scrap 12,346.73 12,346.73 Net sales 10,526,123.29 879,281.00 621,103.60 Cost of sales 8,459,123.86 676,574.44 493,586.33 Cost variances 338,533.82 142,605.32 59,141.90 Reject and rework expense 375,365.43 14,458.48 50,276.62 Allowance for reject reworked (362,378.37) (51,974.56) (23,089.37) Solvent reclaimed (73,532.32) Net cost of sales 8,737,112.42 781,663.68 579,915.48 Gross profit from sales 1,789,010.87 97,617.32 41,188.12 Commercial expenses: Shipping expense 236,303.19 52,134.56 25,638.29 Selling expense 228,702.88 13,069.76 Administrative expense 271,029.57 23,308.08 16,224.58 736,035.64 88,512.40 41,862.87 Net profit (or loss) 1,053,075.23 9,104.92 (674.75) Other income 26,840.82 Other expense (69,401.40) Net revenue 1,010,514.65 *260 Profit and Loss Statement [1944] Pyroxylin Rubber Tolex Dept. Dept. Dept. Sales to customers $ 4,852,063.41 $ 132,215.18 $ 4,017,485.15 Returned goods (37,711.36) (11,798.13) Prepaid freight (28,061.25) (820.88) (4,989.77) 4,786,290.80 131,394.30 4,000,697.25 Revenue from salvaged material 69,587.12 37,769.22 Revenue from sales of scrap Net sales 4,855,877.92 131,394.30 4,038,466.47 Cost of sales 3,890,457.78 112,744.88 3,285,760.43 Cost variances 286,973.73 (5,027.89) (145,159.24) Reject and rework expense 175,465.11 135,165.22 Allowance for reject reworked (130,787.84) (50.10) (156,476.50) Solvent reclaimed (73,532.32) Net cost of sales 4,148,576.46 107,666.89 3,119,289.91 Gross profit from sales 707,301.46 23,727.41 919,176.56 Commercial expenses: Shipping expense 120,365.75 38,164.59 Selling expense 139,804.06 1,213.29 74,615.77 Administrative expense 126,375.05 2,992.87 102,128.99 386,544.86 4,206.16 214,909.35 Net profit (or loss) 320,756.60 19,521.25 704,267.21 Other income Other expense Net revenue *983 Profit and Loss Statement [1945] Total Finishing Corduroy Dept. Dept. Sales to customers $ 9,729,466.99 $ 822,824.97 $ 452,727.99 Returned goods (22,311.04) Prepaid freight (26,808.55) (39.34) 9,680,347.40 822,785.63 452,727.99 Revenue from salvaged material 243,741.15 59,161.35 38,705.37 Revenue from sales of scrap 10,055.63 10,055.63 Net sales 9,934,144.18 892,002.61 491,433.36 Cost of sales 7,924,997.03 681,946.00 390,648.96 Cost variances 111,162.11 53,706.34 83,087.00 Reject and rework expense 308,032.03 18,058.96 38,301.67 Allowance for reject reworked (315,810.50) (55,445.11) (18,270.59) Solvent reclaimed (30,376.45) Net cost of sales 7,998,004.22 698,266.19 493,767.04 Gross profit from sales 1,936,139.96 193,736.42 (2,333.68) Commercial expenses: Shipping expense 227,962.69 48,567.48 21,470.74 Selling expense 269,065.38 12,905.70 Administrative expense 276,921.08 24,194.17 13,447.28 773,949.15 85,667.35 34,918.02 Net profit (or loss) 1,162,190.81 108,069.07 (37,251.70) Other income 25,094.02 Other expense (58,247.44) Net revenue 1,129,037.39 *261 Profit and Loss Statement [1945] Pyroxylin Rubber Tolex Dept. Dept. Dept. Sales to customers $ 4,946,981.16 $ 28,984.32 $ 3,477,948.55 Returned goods (11,946.55) (10,364.49) Prepaid freight (16,617.24) (262.74) (9,889.23) 4,918,417.37 28,721.58 3,457,694.83 Revenue from salvaged material 83,904.08 61,970.35 Revenue from sales of scrap Net sales 5,002,321.45 28,721.58 3,519,665.18 Cost of sales 4,067,243.95 24,042.98 2,761,115.14 Cost variances 66,191.85 (916.19) (90,906.89) Reject and rework expense 117,725.49 133,945.91 Allowance for reject reworked (114,258.38) (127,836.42) Solvent reclaimed (30,376.45) Net cost of sales 4,106,526.46 23,126.79 2,676,317.74 Gross profit from sales 895,794.99 5,594.79 843,347.44 Commercial expenses: Shipping expense 134,506.33 23,418.14 Selling expense 133,903.43 484.35 121,771.90 Administrative expense 139,249.89 1,173.51 98,856.23 407,659.65 1,657.86 244,046.27 Net profit (or loss) 488,135.34 3,936.93 599,301.17 Other income Other expense Net revenue *984 The value of the shipments*262 of pyroxylin manufactured by American producers during the period 1936 to 1945, inclusive, as published by the Department of Commerce was as follows: Total value of Total value of Year pyroxylin industry Number of pyroxylin industry shipments firms shipments per establishment [1936] $ 20,889,112 [20] $ 1,044,456 [1937] 22,263,094 [20] 1,133,155 [1938] 17,478,049 [20] 873,902 [1939] 21,033,279 [21] 1,001,585 [1940] 21,049,683 [21] 1,002,366 [1941] 32,870,665 [21] 1,565,270 [1942] 27,935,912 [21] 1,330,282 [1943] 24,763,095 [21] 1,179,195 [1944] 27,930,186 [21] 1,330,009 [1945] 1 26,576,432 [21] 1,265,544 The production and value of output of vinyl resins during the period 1938 to 1949, inclusive, were as follows: All Vinyl Resins Production Value of output Year (thousands Price per pound (millions of of lbs.) dollars) [1938] 2,486 $ 7.79 [1939] 4,329 2.67 [1940] 7,952 4.75 [1941] 22,980 $ 0.77 17.69 [1942] 52,156 .70 36.51 [1943] 95,564 .54 51.60 [1944] 126,892 .49 62.18 [1945] 122,708 .42 51.54 [1946] 155,609 .39 60.69 [1947] 177,442 .39 69.20 [1948] 218,237 .41 89.48 [1949] 267,686 .42 112.43 *263 Source: Data for 1938-40 were obtained from Union Carbide and Carbon Company which was the sole producer of vinyl resins during this period. Data for 1941-49 were obtained from: U. S. Tariff Commission Reports, Series 2, Report No. 153, p. 54; Report No. 155, p. 43; Report No. 157, p. 62; Report No. 159, p. 46; Report No. 162, p. 47; Report No. 164, p. 45. The demand (estimated in part) for vinyl-coated fabrics (low molecular weight vinyl) during the years 1938 to 1949, inclusive, was as follows: Demand Year 1 (millions of dollars) [1938] $ 0.2 [1939] .3 [1940] .6 [1941] 2.1 [1942] 4.3 [1943] 5.8 [1944] $ 6.6 [1945] 5.3 [1946] 9.7 [1947] 11.2 [1948] 12.8 [1949] 12.5 The average annual sales of the pyroxylin industry for the 4 years immediately preceding each of the taxable years here involved, the *985 pyroxylin sales during each taxable year, and the increased demand factor for pyroxylin for each year may be summarized as follows: Average of annual Business improvement Year sales in the 4 Industry sales in factor preceding years the taxable year column (3) divided by column (2)) (1) (2) (3) (4) Per cent [1942] $ 23,107,919 $ 27,935,912 120.89 [1943] 25,722,385 24,763,095 96.28 [1944] 26,654,839 27,930,186 104.79 [1945] 28,374,964 26,576,432 93.66 *264 The average annual sales of vinyl-coated fabrics (low molecular weight vinyl), based on estimated demand figures, for the 4 years immediately preceding each of the taxable years in issue, the demand for vinyl-coated fabrics during each taxable year, and increased demand factor for vinyl-coated fabrics for each year may be summarized as follows: Demand (millions of dollars) [1945] Average annual sales of 4 prior years $ 0.8 $ 1.82 $ 3.2 $ 4.7 Demand for taxable year $ 4.3 $ 5.8 $ 6.6 $ 5.3 Increased demand 538% 319% 206% 113% During 1942 to 1945, inclusive, Textileather's abnormal income from Tolex (gross profit from sales), direct costs and expenses of marketing Tolex, net abnormal income from Tolex, and net abnormal income due to research and development attributable to other years were as follows: [1945] Abnormal income $ 57,080.02 $ 709,741.12 $ 919,176.56 $ 843,347.44 Excess over 125% of prior 4 years average $ 57,080.02 $ 691,903.61 $ 679,544.95 $ 316,473.15 Direct costs and expenses $ 40,529.80 $ 162,299.14 $ 158,818.00 $ 91,517.35 Net abnormal income from Tolex $ 16,550.22 $ 529,604.47 $ 520,726.05 $ 224,955.80 Business improvement factor 538% 319% 206% 113% Net abnormal income due to research and development attributable to other years $ 2,768.62 $ 149,418.19 $ 227,502.06 $ 179,168.34 *265 We accordingly find that the amounts of $ 2,768.62 for 1942, $ 149,418.19 for 1943, $ 227,502.06 for 1944, and $ 179,168.34 for 1945 represent the taxpayer's net abnormal income attributable to research and development expenditures which should be allocated to each of the years of development in the proportion that each year's development expenses bear to the total thereof. *986 OPINION. The question here presented is whether the taxpayer is entitled to the relief accorded by section 721 (a) (2) (C) of the 1939 Code 1 because of a realization during 1942, 1943, 1944, and 1945 of abnormal income due to exploration, discovery, research, or development attributable to prior years. *266 The taxpayer seeks to qualify for relief under section 721 (a) (2) (C) on the basis of a class of income resulting from conducting research and development of tangible property during the period 1931 to 1940. The respondent contends that the product in question, Tolex, did not result from Textileather's research and development; that, even if it did so result, such research did not extend over a period of more than 12 months; and, further, assuming that Textileather's research extended over a period of more than 12 months, the respondent contends that the abnormal earnings resulting from the sale of Tolex during the period 1942 to 1945, inclusive, were attributable to factors other than research and development during prior years. On brief, respondent asserts in the alternative that if we should find in favor of the taxpayer on the foregoing contentions, the maximum portion of the abnormal income due to research and development and attributable to prior years is $ 1,540.03 for 1942, $ 38,188.35 for 1943, $ 57,194.51 for 1944, and $ 36,048.58 for 1945. The income in question was derived from the sale of Tolex during the years 1942, 1943, 1944, and 1945. The gross income from the *267 sale of the new product, Tolex, during the foregoing years exceeded 125 per cent of the average gross income of the same class for the previous 4 years. Pursuant to the statutory definition of abnormal income contained in section 721 (a) (1) of the 1939 Code, 2 the taxpayer received abnormal income from its Tolex sales during each of the years in issue. *268 *987 The record clearly discloses that the abnormal income so received was to some extent the result of a program of research and development conducted by Textileather. The research and development required to perfect the process of manufacture extended over a period greatly in excess of 12 months. Textileather began its research in 1931 because of the civilian demand for a product superior to pyroxylin. The respondent's argument that the product in question was not the result of the taxpayer's research is without merit. Although it is true that Textileather was unable to perfect a suitable product until the development by Bakelite Corporation of a high molecular weight vinyl resin, there is no statutory requirement that the product resulting from the taxpayer's research and development be completely novel. Ohio Machine Tool Co., 18 T. C. 330; Keystone Brass Works, 12 T. C. 618. Prior to the development of the high molecular weight vinyl resin by the Bakelite Corporation, taxpayer had long been engaged in reasearch and experimentation with various types of resins for the purpose of discovering a suitable base for*269 the material it sought to develop, but was unsuccessful. After determining that the high molecular weight vinyl resin was a satisfactory base for the material it was seeking to produce, it was then necessary to develop suitable plasticizers, lubricants, stabilizers, and pigments which comprised the remaining constituents of the desired compound. Such research and experimental activities conducted by petitioner from 1931 to 1940, leading to the development of the formulae and processes used in the production of Tolex, clearly come within the intendment of section 721 (a) (2) (C) of the 1939 Code. Pantasote Leather Co., 12 T. C. 635. However, the income derived by Textileather during the years in issue from the sale of Tolex was not, to the extent claimed by it, the result of its research and development in prior years. In our view, a portion of such income was attributable to factors other than taxpayer's research and development activities. During the early war years, 1942 and 1943, petitioner was without effective competition in the production of marketable high molecular weight vinyl fabrics. It appears that with its existing facilities taxpayer's*270 market was unlimited even though its prices were controlled, for it is clear that it produced and sold Tolex at peak capacity throughout the years in issue. These factors, coupled with that of increased demand, due in large part to the cessation during the war years in the production of rubber-coated fabrics, lead us to the conclusion that the proportion of its income attributable to research and development in prior years in reality would be in an amount less than that claimed by the taxpayer. Low molecular weight vinyl fabric was an improvement over pyroxylin-coated fabric. *988 It was adaptable to more end uses which more closely approached those of Tolex. However, Tolex was in turn a decided improvement over low molecular weight vinyl fabrics with a resultant greater market. It was the first product which met the specifications of end users, established in 1932 and 1933. We are therefore of the opinion that the respondent's use of the sales experience of low molecular weight vinyl fabrics as a basis for comparison in determining an appropriate business improvement factor is conservative. With the exception of the sales figures for pyroxylin, the record is silent with*271 respect to comparative sales figures indicative of the trend of the coated fabrics industry during the years in issue. With respect to pyroxylin, the record does not identify the end users to whom sales were made. We are therefore unable to determine to what extent the market for pyroxylin was coextensive with the market for Tolex. Utilizing the estimated demand figures for vinyl-coated fabrics for the 4-year period immediately preceding each of the years in issue, we have determined business improvement indices which in our opinion are as accurate as the present record will permit. Cf. William M. Bailey, 15 T. C. 468; Rochester Button Co., 7 T. C. 529. Textileather, on its profit and loss statements for the years 1942 through 1945, has allocated a portion of its administrative expenses as an item of cost incurred in the production and sale of Tolex. We accordingly have adjusted taxpayer's computation of its net abnormal income from Tolex for each year here involved by an amount representing the indicated proportional part of its administrative expenses as an applicable item of direct cost. See Keystone Brass Works, supra;*272 Ohio Machine Tool Co., supra. We are unable to find from the record herein that such factors as outstanding management ability, effective salesmanship, goodwill, the acquisition of additional equipment, or the efficient use of plant facilities and other assets were of more than nominal importance in the realization by Textileather of abnormal income from Tolex sales. Consequently, we have made only a small adjustment in the computation of net abnormal income for the foregoing factors. Ramsey Accessories Manufacturing Corporation, 10 T. C. 482. Although we are not unmindful of the difficulties involved in adjusting and allocating amounts of income attributable to various factors and periods of reporting, after careful consideration of all the evidence presented we have determined that Textileather's net abnormal income due to research and development and attributable to prior years is $ 2,768.62 for 1942, $ 149,418.19 for 1943, $ 227,502.06 for 1944, and $ 179,168.34 for 1945. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. An estimate made by the Department of Commerce for 21 reporting firms.↩ 1. Estimated for years 1938-1945; actual for years 1946-1949.↩ 1. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD. (a) Definitions. -- For the purposes of this section -- * * * * (2) Separate classes of income. -- Each of the following subparagraphs shall be held to describe a separate class of income: * * * * (C) Income resulting from exploration, discovery, prospecting, research, or development of tangible property, patents, formulae, or processes, or any combination of the foregoing extending over a period of more than 12 months; * * *↩ 2. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD. (a) Definitions. -- For the purposes of this section -- (1) Abnormal income. -- The term "abnormal income" means income of any class includible in the gross income of the taxpayer for any taxable year under this subchapter if it is abnormal for the taxpayer to derive income of such class, or, if the taxpayer normally derives income of such class but the amount of such income of such class includible in the gross income of the taxable year is in excess of 125 per centum of the average amount of the gross income of the same class for the four previous taxable years, or, if the taxpayer was not in existence for four previous taxable years, the taxable years during which the taxpayer was in existence.↩