Mesta Mach. Co. v. Commissioner

MESTA MACHINE CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Mesta Mach. Co. v. Commissioner Docket No. 2841. United States Board of Tax Appeals 12 B.T.A. 523; 1928 BTA LEXIS 3516; June 11, 1928, Promulgated *3516 1. Where the petitioner determines its income upon the basis of completed contracts and has performed all of the work required under the contract and received all payments under the contract in 1920, notwithstanding a provision giving one of the contracting parties the right to make an audit within two years, and notwithstanding certain work of rearranging the plant, the contract is completed in the year 1920, according to its terms and income therefrom must be reported within that year. 2. Under the circumstances in this case petitioner is entitled to allocate costs and expenses in the ratio that the two classes of sales bear to the gross sales of the taxable year 1920. 3. Petitioner is entitled to have its profits taxes computed under the provisions of section 328 of the Revenue Act of 1918. W. A. Seifert, Esq., and W. M. Smith, C.P.A., for the petitioner. A. R. Marrs. Esq., for the respondent. MORRIS *523 This is a proceeding for the redetermination of a deficiency in income and profits taxes for the calendar year 1920 in the amount of $578,487.05. There are three issues raised: (1) Whether or not the respondent erroneously*3517 included in taxable net income for the year 1920, the sum of $1,069,451.13, made up of the net sum of $251,600.07 and the sum of $817,851.06, as income alleged to have been derived in said year from certain contracts entered into between the petitioner and the United States Government. (2) Whether or not the respondent improperly allocated the net income for the year 1920 as between Government contracts and income derived from commercial business. (3) The refusal of the respondent to determine the petitioner's excess-profits taxes for the year 1920 under the provisions of sections 327 and 328 of the Revenue Act of 1918. FINDINGS OF FACT. Petitioner was organized and incorporated under the laws of Pennsylvania, December 1, 1898, to engage in the general foundry and machine shop business, manufacturing heavy rolling mill, blast furnace and other heavy machinery for use in the iron and steel industry. The petitioner is the result of a consolidation of the Leechburg Foundry & Machine Co., which was organized in 1887, and Robinson-Rea Manufacturing Co., which had been in existence for approximately seventy-five years up to the time it was taken over by the petitioner. These companies*3518 had, prior to this consolidation, engaged in the same business as that of the petitioner. *524 Petitioner's plants are located in West Homestead, Allegheny County, Pa. On November 2, 1917, petitioner entered into a contract with the United States Shipping Board, Emergency Fleet Corporation, by its agent, American International Shipbuilding Corporation, which provided that the petitioner should furnish, among other things, 70 sets of rough turned forged steel shaftings for steamers then under construction. Articles I, III, IV, and V, the pertinent provisions of that contract read: The Contractor hereby agrees to furnish at its own risk, in accordance with its best usual practice, sets of rough turned forged steel shafting for the fifty (50) 7500 TON STEEL CARGO STEAMERS, and the seventy (70) 8000 TON STEEL TROOP SHIPS to be constructed for the UNITED STATES SHIPPING BOARD EMERGENCY FLEET CORPORATION, under the terms of the contract dated September 13, 1917, and the supplemental order dated October 23, 1917, between the AMERICAN INTERNATIONAL CORPORATION and the UNITED STATES SHIPPING BOARD EMERGENCY FLEET CORPORATION. The contractor agrees to finish the rough-turned*3519 shafting in such time as to enable him to deliver sets of finished shafting f.o.b. cars, West Homestead, Pennsylvania, as follows: 3 complete sets in March, 1918 and 12 complete sets each month thereafter until completion of the work under this contract. Shafting will be manufactured and sets delivered for Steel Cargo Steamers or Steel Troopships in such order as the Owner shall direct from time to time. The price of shafting, rough turned, will be fifteen and one-half (15 1/2) cents a pound, actual weight rough turned, as approved by the Owner, West Homestead, Pennsylvania. The Owner agrees, after submission of monthly statements by the Contractor, covering the weight of rough turned shafting inspected and approved by the Owner during the previous month, that on or about the 20th day of the month, he will pay ninety (90) per cent of the amount of such statement and that the remaining ten (10) per cent will be paid thirty (30) days after the date of approval. The petitioner entered into another contract on April 3, 1918, with the United States Shipping Board, by its agent, the American International Shipbuilding Corporation, which provided, among other things, that the petitioner*3520 should furnish the 70 sets of rough shaftings contracted for under date of November 2, 1917. Articles I, VII, and XI, the pertinent articles of that contract, read: (1) The Contractor hereby agrees to furnish for the seventy (70) "B" vessels to be constructed under the contract between the Purchaser and the Agent, dated September 13, 1917, and under any supplements and addenda thereto the finished shafting, bearings, etc., as hereinafter listed, (a-f) inclusive being shafting, bearings, etc. furnished by the Contractor for one (1) vessel. * * * The shafting, bearings, etc., for the seventy (70) steamers being herein referred to as the "Unites" and each set of Shafting, bearings, etc. as a "unit". *525 (2) The Contractor agrees to make deliveries at the rate of twelve (12) complete Units per month, following the delivery of Shafting for the "A" Steamers, (See Contract 83-SC/SA-17), or alternating with the "A" Shafting as the Purchaser may direct. It is agreed by both parties that time is of the essence of this contract. The Contractor will commence and carry through to completion the work under this contract with dispatch, will give precedence in its plant or plants*3521 to the work hereunder, subject only to the prior rights, if any, of a department of the United States of America, and will not enter into any other contract or undertake any other work or service at its works which will interfere in any material manner with the completion of the work undertaken hereunder. The Purchaser at any time, upon written notice to the Contractor, may cancel this contract as to further performance thereof. Thereupon the Contractor shall complete only such of the units contracted for as the Purchaser shall direct in writing. The cancellation shall not affect the terms of the contract as to the units completed or directed to be completed. The Contractor shall be reimbursed for losses sustained by such cancellation. In computing such losses there shall be included for each unit under construction a proportionate part of the estimated profit on a completed unit. Such proportionate part shall not exceed the percentage which the cost of the unit under construction bears to the cost of a completed unit. In computing profit or cost, the average actual experience of the Contractor on units constructed for the Purchaser shall be taken as the basis of the computation. *3522 In computing such losses the following shall not be included: (a) profits on units not under construction; (b) profits that the Contractor might have earned in other transactions. If the parties cannot agree upon the amount of the loss, it shall be determined on the above basis and by arbitrators, one to be chosen by each party and the third by the two so chosen, and the decision of a majority of the arbitrators shall be binding upon the parties hereto. On or about February 3, 1919, the petitioner received the following telegram from the American International Shipbuilding Corporation, suspending work on 20 of the ship shafts to be furnished by the petitioner under the foregoing contracts: ORDERS S TWO SIX SEVEN FOUR S THIRTY SIX THREE S THIRTY FOUR EIGHTEEN STOP ALL WORK AND HOLD ALL SHIPMENTS ON LAST TWENTY SHIP SETS ONLY LETTER FOLLOWING ACKNOWLEDGE RECEIPT OF INSTRUCTIONS. The petitioner received a further communication from the American International Shipbuilding Corporation dated February 25, 1919, directing the petitioner to suspend work on 15 additional sets of shaftings. That communication reads: Orders S two six seven four S thirty six three S three*3523 four eight one suspend work on fifteen additional sets each order making total of thirty five sets each report status of thirty five sets answering questions outlined in our letter February thirteenth acknowledge receipt. On June 10, 1920, the petitioner entered into a supplemental agreement with the United States Shipping Board, Emergency Fleet Corporation, providing for cancellation of the 35 sets of shafts on which work had already been suspended, which agreement provided for *526 payment of a sum of $450,000 (less certain deductions) in full and final settlement of the 35 canceled shafts. That agreement is as follows: SUPPLEMENTAL AGREEMENT AFFECTING SUB-AGENT'S ORDERS NOS. S-1044, S-2674, S-3418, AND S-3063 TO MESTA MACHINE CO. - CANCELLATION OF PORTIONS OF PURCHASE ORDERS - ADJUSTMENT. AGREEMENT entered into this 10th day of June, 1920, between MESTA MACHINE COMPANY, a corporation organized and existing under the laws of the State of PENNSYLVANIA, doing business at West Homestead, Pennsylvania, (herein called "Contractor"), party of the first part, and the UNITED STATES SHIPPING BOARD EMERGENCY FLEET CORPORATION, a corporation organized and existing under the*3524 laws of the District of Columbia (herein called "Owner") acting for and on behalf of the UNITED STATES OF AMERICA (herein called "United States"), party of the second part, WITNESSETH THAT: WHEREAS, a certain contract was entered into on the 13th day of September, 1917, between the American International Corporation, a corporation organized and existing under the laws of the State of New York, (herein called "Agent") and the Owner, No. 83-SC, for the construction of certain vessels and giving the Owner the option to call for the construction of certain additional vessels; and WHEREAS, on the 23rd day of October, 1917, the Owner exercised the option aforesaid and issued an order (herein called "Option Order"), calling for the construction of seventy (70) additional vessels; and WHEREAS, an agreement was entered into between the Agent and the American International Shipbuilding Corporation, a corporation organized and existing under the laws of the State of Delaware (herein called "Sub-Agent"), by which the Sub-Agent was authorized and employed to do the construction work of the Agent and place contracts, orders and commitments in the name of the Owner; and WHEREAS, it was desirable*3525 in the public interest to suspend operations on thirty-five (35) of said seventy additional vessels under the .option Order, to that end, the Sub-Agent, at the request of the Owner, on the 3rd day of February, 1919, suspended operations on twenty (20) of said thirty-five vessels, and on fifteen (15) of said thirty-five vwssels on the 25th day of February, 1919; and WHEREAS, on the 30th day of January, 1918 the Sub-Agent issued to the Contractor its Purchase Order S-1044, providing for the manufacture and delivery of fifty (50) sets of Rough Turned Shafting for "A" type ships and seventy (70) sets of Rough Turned Shafting for "B" type ships at a purchase price of fiteen and one half ($.15 1/2) Cents per pound; and WHEREAS, on the 16th day of April, 1918, the Sub-Agent issued to the Contractor its Purchase Order No. S-2674, providing for the manufacture and delivery of seventy (70) sets of Finished Shafting and Fittings for type "B" ships at a total purchase price of One Million Eight Hundred Sixty-nine Thousand Two Hundred and Ten ($1,869,210.00) Dollars; and WHEREAS, on the 6th day of June, 1918, the Sub-Agent issued to the Contractor its Purchase Order No. S-3063, providing*3526 for the manufacture and delivery of seventy (70) sets of Spare Coupling Bolts with Nuts at a total purchase price of Eighty-Six Hundred and Eighty ($8680.00) Dollars; and WHEREAS, the Contractor thereafter issued to the Pittsburgh Screw and Bolt Company (herein called "Sub-Contractor"), its Order (herein called "First *527 Order"), providing for the manufacture and delivery of space Coupling Bolts with Nuts required under said Purchase Order No. S-3063; and WHEREAS, Prior to the month of February, 1919, the Sub-Agent issued to the Contractor its Purchase Order S-3418 (all of above numbered Purchase Orders being hereinafter collectively referred to as the "Purchase Orders"), providing for the manufacture and delivery of seventy (70) sets of Forged Steel Taper Coupling Bolts with Nuts and Split Pins at a total purchase price of Seven Thousand One Hundred and Forty ($7,140.00) Dollars; and WHEREAS, the Contractor thereupon issued to the Sub-Contractor a further Order (herein called "Second Order"), providing for the manufacture and delivery of said seventy (70) sets of Forged Steel Taper Coupling Bolts with Nuts and Split Pins; and WHEREAS, it was desirable in the public*3527 interest to suspend operations under said Purchase Orders and to that end, the Contractor, at the request of the Owner and the Sub-Agent, on the 3rd day of February, 1919, suspended operations under said Purchase Order No. S-1044 upon twenty (20) sets of said Rough Turned Shafting for "B" type ships and on the 25th day of February, 1919, suspended operations thereunder upon fifteen (15) additional sets of said Rough Turned Shafting for "B" type ships; and WHEREAS, it was desirable in the public interest to suspend operations under said Purchase Orders and to that end, the Contractor, at the request of the Owner and the Sub-Agent, on the 3rd day of February, 1919, suspended operations under said Purchase Order No. S-1044 upon twenty (20) sets of said Rough Turned Shafting for "B" type ships and on the 25th day of February, 1919, suspended operations thereunder upon fifteen (15) additional sets of said Rough Turned Shafting for "B" type ships; and WHEREAS, it was desirable in the public interest to further suspend operations under said Purchase Orders, and to that end, the Contractor, at the request of the Owner and the Sub-Agent on the 3rd day of February, 1919, suspended operations*3528 under said Purchase Order No. S-2674 upon twenty (20) sets of said Finished Shafting and Fittings for "B" type ships, and on the 25th day of February, 1919, suspended operations thereunder upon an additional fifteen (15) sets of said Finished Shafting and Fittings for "B" type ships; and WHEREAS, it was desirable in the public interest to further suspend operations under said Purchase Orders, and to that end, the Contractor, at the request of the Owner and the Sub-Agent on the 3rd day of February, 1919, suspended operations under said Purchase Order No. S-3063, upon twenty (20) sets of said Spare Coupling Bolts with Nuts and on the 25th day of February, 1919, suspended operations upon an additional fifteen (15) sets of said Spare Coupling Bolts with Nuts; and WHEREAS, it was desirable in the public interest to further suspend operations under said Purchase Orders, and to that end, the Contractor, at the request of the Owner and the Sub-Agent on the 3rd day of February, 1919, suspended operations under said Purchase Order No. S-3418 upon twenty (20) sets of said Forged Steel Taper Coupling Bolts with Nuts and Split Pins, and on the 25th day of February, 1919, suspended operations*3529 thereunder upon an additional fifteen (15) sets of said Forged Steel Taper Coupling Bolts with Nuts and Split Pins; and WHEREAS, the Sub-Contractor alleges that on account of the suspensions under said Purchase Orders Nos. S-3063 and S-3418, that it subsequently thereto, at the request and direction of the Contractor suspended operations under the Orders; and *528 WHEREAS, the Purchase Orders and the Orders have not been completely performed, but in preparation therefor and as a part of complete performance, the Contractor and the Sub-Contractor have properly employed capital, made expenditures, incurred obligations and liabilities, including disbursements for work, labor and services necessarily rendered in connection therewith; and WHEREAS, the parties hereto now desire to cancel the uncompleted portions of said Purchase Orders and Orders, and by this agreement compromise, adjust and make full and final settlement of all matters in connection therewith, NOW, THEREFORE, in consideration of the premises and of the mutual covenants of the parties herein contained, it is agreed as follows: ARTICLE I. The uncompleted portions of the Purchase Orders and Orders are hereby*3530 terminated, cancelled and annualled. ARTICLE II. (1) The Owner shall forthwith pay to the Contractor the sum of Four Hundred Fifty Thousand ($450,000.00) Dollars, from which shall first be deducted: (a) the sum of One Hundred Fifty-two Thousand Sixty-five ($152.065.00) Dollars, which said sum represents the balance now due and owing to the Owner by the Contractor on account of the cost of the erection of buildings and installation of equipment therein at Contractor's plant at West Homestead, Pennsylvania, as evidenced by a certain contract in writing between the Owner and the Contractor bearing date of December 5th, 1917, (b) all payments and/or advances heretofore made by the Owner and/or the Sub-Agent to the Contractor and/or the Sub-Contractor on account of the partial suspension and cancellation of said Purchase Orders and Orders. (2) Upon the deduction of said sum of One Hundred Fifty-two Thousand Sixty-five ($152,065.00) Dollars, as provided in sub-paragraph (a) of Section (1) of this Article II to be made from the sum of Four Hundred Fifty Thousand ($450,000.00) Dollars therein in Section (1) agreed to be paid to Contractor, the Owner shall promptly execute*3531 such proper bills of sale and/or other documents as may be required under the terms of said agreement of December 5th, 1917, or as may be necessary to convey to the Contractor all of Owner's right, title and interest in and to such buildings and the equipment therein installed. ARTICLE III. Neither the owner nor anyone claiming or to claim under it shall have any right, title or interest in or to any of the material of any nature whatsoever, heretofore procured for or on account of said Purchase Orders and Orders. ARTICLE IV. It is hereby expressly understood and agreed that the Owner and/or the Sub-Agent shall not be liable in any manner for the adjustment or settlement of any of the Contractor's Sub-Contracts or Commitments of any nature whatsoever made in connection with or on account of said Purchase Orders and Orders. ARTICLE V. All disbursements, settlements or adjustments made under or growing out of the Original Purchase Orders or Orders, or any supplement thereto, or of this *529 agreement, shall be subject to such audit or audits, as may be determined by the General Comptroller of the Owner, which audit or audits, however, must be begun within two*3532 years from the date hereof; and all books, accounts, records, agreements, documents or other data which, in the opinion of such General Comptroller, may be necessary for such audit or audits shall be at his disposal or that of his duly authorized representative. Any omission, irregularities, or discrepancies prejudicial to the interest of the Owner, disclosed by any such future audit, shall be subject to adjustment. ARTICLE VI. The Contractor for itself, its successors and assigns does hereby waive all claims to prospective profits which it might have made from the performance of those portions of said Purchase Orders and Orders, which under the terms of this agreement, will not be performed and does remise, release and forever discharge the Agent, the Sub-Agent, the Owner and the United States of and from all and all manner of debts, dues, sum or sums of money, accounts, reckonings, claims and demands whatsoever, due or to become due, in law or in equity, under or by reason of or which may arise out of said Purchase Orders and Orders, or the partial suspension and cancellation thereof; or any order, authorization, agreement or promise, either verbal or in writing, expressed*3533 or implied, given or alleged to have been given by the Owner or any of its agents or representatives in connection therewith. ARTICLE VII. The Contractor agrees to execute and deliver to the Owner all papers, instruments and certificates which the Owner may deem necessary to effectuate the intent of this agreement. ARTICLE VIII. This agreement shall be executed in triplicate and the respective copies shall be known as Parts I, II and III. Parts I and III shall be delivered to the Owner and Part II shall be delivered to the Contractor. Said respective parts shall be of equal force and effect for any and all purposes. Pursuant to the foregoing supplemental agreement the orders for 35 sets of the 70 B ship shafts were canceled, work on which had been suspended in February, 1919. Petitioner proceeded with the work on the remainder of the 35 sets of B ship shaftings which had not been canceled, and made shipments: [1918] 2 sets [1919] 24 sets [1920] 9 sets Total 35 sets The final shipment of these shaftings was made in July, 1920. Petitioner received from the United States Shipping Board in payment of the 35 shaftings which were completed: [1918] $91,929.70 [1919] 1,103,156.40 [1920] 413,683.65 Total 1,608,769.75 *3534 *530 The amount of $1,608,769.75, representing the gross income from the 35 shaftings completed and delivered, was not taken up by the petitioner as income until 1923. Petitioner received a further amount of $450,000 in 1920 (less certain deductions) representing final settlement under the supplemental contract hereinabove quoted, making the total amount received in 1920 on account of the 70 B ship shaftings of $2,058,769.75. The net amount derived from the supplemental contract of June 10, 1920, or $251,600.07, was reported as "Other Income" in the petitioner's return for the taxable year 1920. The work of making these ship shaftings was different from the usual work done by the petitioner. The shaft of a ship extends from the engine room or turbine of a ship to the propeller for driving the propeller. The process of making and finishing these shaftings is briefly as follows: What is known as ingots are made by pouring metal from an open hearth furnace into the ingot moulds - these ingots are then taken to the forge shop where they are reheated and forged into shape under a large press. These forgings are then placed in what are known as heat-treating ovens, so*3535 as to relieve molecular strains and bring the material into condition to meet the specifications; after that the tests are made to determine whether they are up to specifications and the forgings are placed in the machine shop where they are finished. A complete ship shaft consists of 7 sections, each approximately 20 feet in length, or a total length of the entire shaft of about 140 feet. The total weight of a shaft is about 160,000 pounds. In 1917, when the contract was entered into with the Shipping Board, the petitioner's plant was very crowded and because of the nature of the work to be done was very unsuited therefor. Consequently, it became necessary to so arrange the plant that this work could be done in the most expeditious manner; the foundry department was moved to another building and in the building vacated, the petitioner fitted up a complete forge shop. New equipment, such as presses, boilers, furnaces, and machine tools, etc., were installed in this new shop. The petitioner did not await the erection of suitable facilities which were to be erected by the Shipping Board for doing the work required under these contracts. In 1920, after the 35 shaftings had all*3536 been completed and delivered, it was then found necessary to rearrange the plant again in order to meet the normal demands of the business. Accordingly, two 1,500-ton presses and the heat-treating furnaces were torn down. The machine tools were moved. The lighting and sewerage systems were changed. A heating system was put in the finishing department, etc. These changes were made in the years 1920, 1921, 1922, and practically completed in 1923. All of the work was not completed in 1920 because of demands for commercial *531 work - only changes were made that were absolutely necessary to produce this commercial work efficiently. The cost of this rearrangement was charged to profit and loss. It was the custom of the petitioner to contract for all of the necessary raw materials as soon as a sales contract was entered into. Pursuant to that custom when the contract of November 2, 1917, was entered into it was necessary to purchase additional raw materials to cover those additional sales, and accordingly contracts were let for sufficient material to manufacture the entire 70 shafts at prices prevailing at that time. Not having begun to receive materials contracted for*3537 on the B shafts contract, the petitioner used some raw materials purchased for commercial work at lower prices. At the time the Shipping Board canceled the 35 sets of shaftings the petitioner had, either on hand or on contract, sufficient raw materials for the completion thereof. Petitioner had no cancellation provisions in its purchase contracts, so it was compelled to accept the materials contracted for. The petitioner kept its books and determined its income on the basis of completed contracts, that is, its income from contracts was not determined until the contract had been completed. The petitioner received payments on account as work progressed under a contract, which payments were credited to "billings on uncompleted contracts," where it was carried until the contract was completed, when it was taken up as income. The costs on the other hand were carried as "work in progress" pending the completion of the contract. In computing its net income for 1920 petitioner reported in its income and profits-tax return: Commercial sales $4,887,711.41 Government sales 3,536,223.54 Gross sales 8,423,934.95 The above sales do not include any portion of the*3538 gross amount of $1,608,769.75 received by the petitioner in payment for the 35 sets of B ship shaftings completed, which sum was not taken up as income until 1923. Nor do the gross sales above include any portion of the $450,000 received by the petitioner under the supplemental agreement of June 10, 1920. The net amount received under that agreement was reported in the petitioner's return for 1920 as "Other Income." The respondent, on the other hand, after having audited petitioner's return for 1920, determined its sales to be as follows: Commercial sales $6,496,475.76 Government sales 1,927,453.79 Gross sales 8,423,929.55 *532 The above sales do not include the price of the ship shafts or the receipts from the cancellation contract. Those amounts were included in the respondent's computation of net income, but were not included in the gross sales. The following is a computation or net income for 1920 as made by the respondent: Total Commercial Government Sales (exclusive of sales of 35 "B" ship shafts of $ 1,608,769.75) $8,423,929.55 $6,406,475.76 $1,927,453.79 Ratio 100% 77.119% 22,881% Deduct - Manufacturing costs and other expenses on a basis of sales as above - details on 2 E 8,048,641.45 6,207,031.80 1,841,609.65 375,288.10 289,443.96 85,844.14 251,600.07 Add - Cash received in settlement of war claims, Miscellaneous income applicable to commercial activities 64,260.92 64,260.92 251,600.07 Net taxable income before taking up income from sale of 35 "B" ship shafts 691,149.09 353,704.88 337,444.21 Ratio 100% 51.17% 48.83% Add - Difference between sales and so-called manufacturing cost of sale of 35 "B" ship shafts 817,851.06 817,851.06 Revised taxable net income per Bureau letter of January 29, 1925 1,509,000.15 353,704.88 1,155.295.27 Ratio on above basis and per Bureau letter of January 29, 1925 100% 23.44% 76.56% *3539 The gross sales for the year 1920, including all of the amounts received by the petitioner from the contracts hereinabove, are: Total Commercial Government Gross sales per books $8,423,929.55 $6,496,475.76 $1,927,453.79 Gross amount of "B" shafts completed 1,608,769.75 1,608,769.75 Gross amount from "B" shafts canceled 450,000.00 450,000.00 Total gross sales 10,482,699.30 6,496,475.76 3,986,223.54 In the computation of net income for the year 1920, the respondent arrived at the net profit on B shafts completed, separately from the total net income, as follows: Gross receipts from "B" ship shafts completed $1,608,769.75 Deduction therefrom of the book figure of cost arriving at the figure which represents gross manufacturing profit in the petitioner's books 793,918.69 814.851.06 Add to that sum an amount of $3,000 adjustment made by the respondent 3,000.00 Net income found by respondent from 35 "B" shaftings 817,851.06 The sum of $817,851.06 (less the $3,000 adjustment above), represents the gross manufacturing profit according to the petitioner's books, which figure does not include any portion of the*3540 unabsorbed shop burden, inventory adjustments, differential in price of metal, plant changes and extraordinary expenses, etc. *533 On account of the urgent demand for the petitioner's product in the years 1918, 1919, and 1920, and the labor conditions prevailing during those years, the petitioner was compelled to employ inefficient labor in its plant and in its cost department. As a result it was impossible to collect proper data entering into the costs; consequently the cost records were incorrect and in very bad condition. The labor in the plant would either fail to weigh the raw materials going into the furnace, or, if they did weigh them, the weights were frequently incorrect due to broken scales. Therefore, when it was found that the materials had not been properly weighed, it was necessary to estimate the weight in order that some record could be made in the cost records. The cost records were behind several months during the period 1917 to 1920. They were defective in that materials were used and not reported, and the forge department, where most of the time was spent, failed to render correct reports on time spent on Government forgings. It was in fact practically*3541 impossible to determine and distribute correct costs from the records in their condition at that time. On account of the fact that the cost records were so far behind and so poorly kept the burden rates could not be periodically adjusted to meet current economic conditions so all of the burden applying to a particular order could not be determined. The burden was charged to specific jobs on an hourly basis, a price per hour was established. The rates so established in 1918 and 1920 were not high enough to absorb the burden. Petitioner attempted to rectify those deficiencies in the cost department but even experts could not aid it, because of the labor situation then existing. the unabsorbed burden carried on the books of the petitioner at the end of 1918 amounted to $264,167.90, and at the end of 1920, $513,000.95. There was an overabsorbed burden figure in the books for 1919 of $48,509.88. None of the amounts of unabsorbed or overabsorbed burden were included in the costs of $793,918.69 carried in the books of account and used by the respondent in arriving at the net income of $817,851.06 from B shaftings. There was a shortage in inventory of about $740,000 in 1918, but*3542 no effort was made to apply that amount to any specific job or order in applying costs, nor was any portion of it applied to the costs of the B ship shafts contract. Petitioner maintained an office in Washington, D.C., during the period January, 1918, to April, 1923, where the president of the company spent most of his time, but neither the cost of maintaining this office, nor any portion of the salary of the president was charged to the B ship shaft contract, or to any other contract, notwithstanding that this office was maintained exclusively for Government work, and notwithstanding that the president spent most of his time on *534 Government work. Harry F. Wahr, secretary and sales manager, also spent considerable time on Government contracts, but his salary, like that of the president, was charged to general expense. The petitioner manufactured certain machines which it required for use in its own plant instead of purchasing them from other manufacturers. Petitioner had manufactured similar machines for its customers. The total cost to manufacture the machines installed in its plant for its own use was $540,471.42. Those same machines, if sold to the public, would*3543 sell for $637,724.98. Petitioner also manufactured certain special machinery, which it installed in its own plant, which it entered in its books of account at a cost figure of $254,860.74. These machines were not of the type regularly sold to petitioner's customers. During the taxable year the petitioner had the use of Government facilities which cost $1,309,839.09. These facilities were provided by the United States Government and were used by the petitioner without any cost to it whatsoever. Petitioner could also use those facilities for commercial work when there was not sufficient Government work to require the use of all of the facilities. In January, 1920, the petitioner owned 16,709 patterns and equally as many designs. The cost of those patterns, which were constantly being used in petitioner's business, determined by taking a representative average from the books of account, was $1,971,662 before deducting depreciation. The designs had as great, if not a greater value than the patterns. No depreciation was taken within the taxable year on either patterns or designs, nor was any portion of the value of these patterns or designs included in invested capital. *3544 Petitioner owned a great number of patents in the year 1920 which had not been capitalized. The following is a list of said patents: Number patent Date of patent Name of patentee 749823 Jan. 19, 1904 A. T. Keller 785613 Mar. 21, 1905 A. H. Helander 785614 Mar. 21, 1905 A. H. Helander 790964 May 30, 1905 A. T. Keller 814433 Mar. 6, 1906 C. E. Conkling 829964 Sept. 4, 1906 A. H. Helander 833473 Oct. 16, 1906 Geo. Mesta 870285 Nov. 5, 1907 A. K. Hamilton and A. T. Keller. 874018 Dec. 17, 1907 C. J. Mesta 884278 Apr. 7, 1908 A. T. Keller 887634 May 12, 1908 A. H. Helander 893359 July 14, 1908 Fr. Ottesen 894381 July 28, 1908 H. Hankens 908405 Dec. 29, 1908 A. H. Helander 917452 Apr. 6, 1909 A. T. Keller 937163 Oct. 19, 1909 F. E. Mesta 942780 Dec. 7, 1909 L. Iverson 944343 Dec. 28, 1909 F. E. Mesta 951769 Mar. 8, 1910 F. E. Mesta 954396 Apr. 5, 1910 J. L. Klindworth 958503 May 17, 1910 J. L. Klindworth 958705 May 17, 1910 Geo. Mesta 982680 Jan. 24, 1911 L. Iverson 991070 May 2, 1911 A. T. Keller 1006582 Oct. 24, 1911 F. E. Mesta 1028356 June 4, 1912 L. Iverson Dec. 3, 1912 A. A. Neave Shear table 1056203 Mar. 18, 1913 A. A. Neave 1068243 July 22, 1913 L. Iverson 1135510 Apr. 13, 1915 P. Filipietz 1197376 Sept. 5, 1916 L. Iverson 1224310 May 1, 1917 C. J. Mesta and C. L. W. Trinks. 1359601 Nov. 23, 1920 L. Iverson *3545 Number patent Covering Assignment to M.M. Co. 749823 Universal mills One-half. 785613 Steam condensers Whole. 785614 Steam condensers Whole. 790964 Blowing engine valve One-half. 814433 Speed governor Whole. 829964 Regulating device for condensers Whole. 833473 Blowing engine valve Whole. 870285 Hydraulic counterbalance for rolling mills One-fourth. 874018 Chilled castings Whole. 884278 Rolling mills One-half. 887634 Barometric condensers Whole. 893359 Combustion engines Whole. 894381 Blowing engine valves Whole. 908405 Barometric condensers Whole. 917452 Valve gear for engines One-half. 937163 Methods for making castings, ingots, etc Whole. 942780 Coupling devices Whole. 944343 Annealing boxes Whole. 951769 Molds for chill rolls Whole. 954396 Gages for shears Whole. 958503 Tipping furnaces, mixers, etc Whole. 958705 Blowing engines or compressors Whole. 982680 Air valves Whole. 991070 Rolling mills One-half. 1006582 Billet turning devices Whole. 1028356 Steam hydraulic presses Whole.1045873 Dec. 3, 1912 Whole. 1056203 Rolling mills Whole. 1068243 Steam hydraulic presses Whole. 1135510 Universal couplings Whole. 1197376 Gear planing machine Whole. 1224310 Barometric condensers Whole. 1359601 Universal couplings Whole. *3546 *535 The above patents covered improvements to rolling mill and blast furnace machinery. There were patents controlling pickling machines which were used by all tinplate plants, sheet mills, and by a number of automobile manufactures. Petitioner also had several licenses to build machinery under patents not owned by it. The following is a list of those licenses: Date of agreement Agreement with July 31, 1899 Geo. Mesta Aug. 11, 1910 Haniel & Lueg, Dusseldorf, Germany. Mar. 3, 1913 L. Iverson Nov. 30, 1914 Stumpt Unaflow Engine Co., Syracuse, N.Y. A. H. Helander Date of agreement Covering - Patents July 31, 1899 Pickling machines 935,619 - Sept. 28, 1909. 1,107,821 - Aug. 18, 1914. Aug. 11, 1910 Steam hydraulic presses and 819,988-May 8, 1906. 842,949 shears. - Feb. 5, 1907. Mar. 3, 1913 Valves for blowing engines. U.S. 1,012,359 - Dec. 19, 1911. Canadian, 141,379 - June 25, 1912. Nov. 30, 1914 Unaflow engines and accessories. 1,042,168 - Oct. 22, 1912. Barometric condensers The cost of none of the foregoing patents or licenses has been included in the invested capital of the*3547 petitioner. The gross sales of articles protected by the above patents for the year 1920 were $1,336,139.94, the net profit from which was $196,071.65. Patented articles represented 20.57 per cent of the total commercial sales. The following is a summary of profits derived from patented articles: GENERAL SUMMARY Net selling Manufacturing Net profit value cost Unaflow engines $45,700.00 $58,754.75 (Loss) $13,054.75 Pickling machines and parts 153,394.73 84,425.89 68,968.84 Iverson valves, etc 224,536.33 127,694.58 94,814.75 Mesta blowing engines and condensers 576,178.17 555,201.88 20,976.29 Steam-Hyd presses and shears 246,049.24 225,909.76 20,139.48 Mesta gas engines and parts 52,364.86 57,684.59 (Loss) 5,319.73 Barometric condensers and parts 37,916.61 28,396.84 9,519.77 Total 1,336,139.94 1,140,068.29 196,071.65 Total commercial sales 6,496,475.76 *536 The actual cost of patterns, patents and designs developed by the petitioner can not be determined. The respondent denied petitioner's application to have its excess-profits tax for the year 1920 computed under section 328 of the Revenue Act*3548 of 1918. OPINION. MOSSIS: The first assignment of error relates to the inclusion in income for the taxable year of the income from the B ship shaft contracts. Petitioner contends that its practice has been to report income from contracts on a "completed contract basis" and therefore these contracts here under consideration not having been completed in 1920, the income therefrom should not be included in gross income in that year. It contends that the contracts were not completed in 1920 because: (1) A considerable amount of work in connection with the contract was not completed until 1923, (2) the cost of work performed under said contract could not be determined until all work had been completed in 1923, (3) article 5 of supplemental agreement of June 10, 1920, required petitioner to keep its books of account open with respect to these "B" shaftings subject to audit until June 10, 1922, and that therefore the amount so received under the contract was subject to further adjustment, (4) the sovereign entity having kept its contract open for two years, the respondent can not consider it closed for income-tax purposes, (5) the petitioner had a claim against the Shipping Board*3549 on account of said contract which was not finally determined until 1923. Section 213 of the Revenue Act of 1918 provides: That for the purposes of this title (except as otherwise provided in section 233) the term "gross income" - (a) Includes gains, profits * * *. The amount of all such items shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under subdivision (b) of section 212, any such amounts are to be properly accounted for as of a different period; * * *. Section 212(b) of the same Act provides: The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. * * * Article 36 of Regulations 45 reads in part as follows: Long-term contracts*3550 - Persons engaged in contracting operations, who have uncompleted contracts, in some cases perhaps running for periods of several *537 years, will be allowed to prepare their returns so that the gross income will be arrived at on the basis of completed work; that is, on jobs which have been finally completed any and all moneys received in payment will be returned as income for the year in which the work was completed. If the gross income is arrived at by this method, the deduction from such gross income should include and be limited to the expenditures made on account of such completed contracts. * * * There is no dispute with respect to the petitioner's right to invoke the provisions of article 36 and report its income on a completed-contract basis; therefore the question is whether the income from the B ship shaft contract should be taken up for 1920 or a subsequent year on the completed-contract basis. We must determine from the contract and from the acts of the parties thereunder whether the contract was completed within the taxable year 1920. The testimony shows that the petitioner completed and shipped the 35 B ship shafts, the contracts for which had not been*3551 canceled - two in 1918; 24 in 1919; and 9 in 1920. Furthermore, that the final shipment of shafts was made in July, 1920. Petitioner received the following sums representing the total payment on account of the 35 completed shafts: [1918] $91,929.70 [1919] 1,103,156.40 [1920] 413,683.65 Total 1,608,769.75 It is clear therefore, that the purpose which moved the parties to contract, that is, the performance of work on the one hand, and the payment of money on the other, was totally completed in 1920. Counsel for the petitioner argues that the cost of rearranging its plant, which was not completed until 1923, was a part of the cost of this contract in question, and that because of the petitioner's inability to determine the cost of such rearrangement until the work was completed in 1923, the work under the contract was not completed until that time. We can not agree with petitioner's counsel for the reason that he is injecting collateral matters to substantiate the fact that the contract itself was not completed in 1920. Assuming that these charges should have been made against this contract, it does not appear from the testimony that there was any concerted effort*3552 made by the petitioner to complete its plans of rearrangement within any reasonable time. In fact it appears that these changes were being made as they were absolutely necessary to produce commercial work efficiently. To hold that the rearrangement should be completed before the income derived from such a contract should be reported would enable a taxpayer to postpone indefinitely the returning of income which has actually been received, which result, in our *538 opinion, is inconsistent with the theory of the tax laws. We have already held, however, that while such charges may have been occasioned by war contracts they do not appertain thereto, but rather to the production of future income. . Article 5 of the supplemental agreement of June 10, 1920, does not in our opinion prevent this contract from being completed according to its terms in 1920. We concede that there may be necessity for some adjustment under the article referred to, but we can not agree with the contention that the contract thereby becomes incomplete and that the income therefrom should not be reported until after the time when the Government's right*3553 to make an audit was barred by article 5 above. To allow this argument to prevail we might, with equal force, assume that no contract is completed until the statute of limitations with respect to contracts has expired. The contract with the United States Shipping Board did not require the petitioner to keep the "contract open," it simply provided - which was the common practice in all Government contracts - that the Government should be permitted to audit the petitioner's books at any time within two years for the purpose of determining whether or not the provisions of the contract had been complied with. If they had, there was no possibility of an adjustment after audit. While the facts in , are not identical with the facts in the petitioner's case, the same general considerations are involved. The petitioner in that case attempted to withhold from gross income in the taxable year certain estimated sums required to fulfill a maintenance provision in the contract extending over a period of years. The Board said in that case "the maintenance provision may have been and was embodied in the contracts for the construction, but*3554 it was a separate and collateral undertaking based upon a contingency. Any taxpayer suspending business at the end of any taxable year and having at that time future collateral undertakings, might possibly find it necessary to expend a portion of the income received in the prior year in fulfilling obligations in connection with transactions which produced said income if occasion therefor should arise." But the Board says further "this does not entitle a taxpayer to withhold from taxable income, in addition to all expenses paid or incurred within the taxable year, a liberal portion of the income because he may possibly be called upon to expend sums to make good guaranties entered into respecting work completed and for which he received full compensation within the taxable year." As has been stated the right of the petitioner to compute its taxes on the long term contract basis has not been questioned. Article 36 *539 of Regulations 45 quoted above permits the taxpayer to report gross income on the basis of completed work, which article says "that all moneys received in payment will be returned as income for the year in which the work was completed." That sentence unquestionably*3555 relates to the performance of the work specified in the contract. Finding as we do that the ship shafts provided for in the contract in question had been completed in 1920 and that payment had been received therefor, we must hold that the contract was completed in 1920 and that the income therefrom should be reported for that year. The second assignment of error relates to the respondent's method of allocating the net income of the petitioner for the taxable year 1920 as between Government and commercial sales. There is no dispute with respect to the amount of net income for the taxable year; both petitioner (assuming that the income from the ship shaft contract is taxable income for 1920) and respondent having determined it to be $1,509,000.15. In making the allocation between Government and commercial income, the respondent found net income from commercial sales of $353,704.88; net income from Government sales of $1,155,295.27; total net income $1,509,000.15. The petitioner on the other hand now computes net income from commercial sales, $959,912.82; net income from Government sales, $549,087.33; total net income, $1,509,000.15. It will be seen from the computation of net*3556 income in the findings of fact as made by the respondent that the total sales used for that computation amounted to $8,423,929.55 allocated $6,496,475.76 to commercial sales and $1,927,453.79 to Government sales. The figure of total sales as found by the respondent does not include any portion of the amounts received by the petitioner in payment of 35 B ship shafts which were completed and delivered, nor does it include the amount received in settlement under a supplemental agreement between the United States Shipping Board and the petitioner dated June 10, 1920. The respondent then determined the percentage of commercial and Government sales to total sales and by applying those percentages to total manufacturing cost of $8,048,641.45 (excluding all costs in connection with B shafts) he found cost of manufacturing applicable to commercial sales, $6,207,031.80, and as applicable to Government sales $1,841,630.65, arriving at a profit from commercial sales of $289,443.96 and income from Government sales of $85,844.14. The respondent then added to income from commercial sales miscellaneous income in the amount of $64,260.62 making a total income from commercial sales of $353,704.88. *3557 He then added to the income from Government sales $251,600.07 net amount received under supplemental agreement of June 10, 1920, also $817,851.06 alleged to be net income from the 35 *540 B ship shafts, making total net income from Government sales of $1,155,295.27. The petitioner contends that there should be added to the gross sales of $8,423,929.55 the gross sum of $450,000 received under the cancellation agreement of June 10, 1920, and also the gross income from 35 B ship shafts completed in the amount of $1,608,769.75, thereby increasing the total gross sales to $10,482,699.30, making the allocation of gross sales $6,496,475.76 to commercial sales and $3,986,223.54 to Government sales. The petitioner further contends that the percentages of commercial and Government sales to the total sales should then be determined and applied to the total cost of sales in determining the net income from these two classes of sales. Section 301(a)(c) of the Revenue Act of 1918 provides as follows: (a) That in lieu of the tax imposed by Title II of the Revenue Act of 1917, but in addition to the other taxes imposed by this Act, there shall be levied, collected, and paid*3558 for the taxable year 1918 upon the net income of every corporation a tax equal to the sum of the following: * * * (c) For the taxable year 1919 and each taxable year thereafter there shall be levied, collected, and paid upon the net income of every corporation which derives in such year a net income of more than $10,000 from any Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, a tax equal to the sum of the following: (1) Such a portion of a tax computed at the rates specified in subdivision (a) as the part of the net income attributable to such Government contract or contracts bears to the entire net income. In computing such tax the excessprofits credit and the war-profits credit applicable to the taxable year shall be used; (2) Such a portion of a tax computed at the rates specified in subdivision (b) as the part of the net income not attributable to such Government contract or contracts bears to the entire net income. For the purpose of determining the part of the net income attributable to such Government contract or contracts, the proper apportionment and allocation of the deductions with respect*3559 to gross income derived from such Government contract or contracts and from other sources, respectively, shall be determined under rules and regulations prescribed by the Commissioner with the approval of the Secretary. Article 715 of Regulations 45 provides: Whenever it is necessary to determine the portion of the net income derived from or attributable to a particular source, the corporation shall allocate to the gross income derived from such source, and to the gross income derived from each other source, the expenses, losses, and other deductions properly appertaining thereto, and shall apply any general expenses, losses and deductions (which can not properly be otherwise apportioned) ratably to the gross income from all sources. The gross income derived from a particular source, less the deductions properly appertaining thereto and less its proportion of any general deductions, shall be the net income derived from such source. The corporation shall submit with its return a statement fully explaining the manner in which such expenses, losses, and deductions were allocated or distributed. *541 The testimony offered by the petitioner with respect to the inaccuracy*3560 of its cost records for the years 1918, 1919, and 1920, also with respect to the impossibility of properly and accurately distributing costs and applying them to particular orders, is most convincing. The testimony of petitioner's witnesses to the effect that the sum of $817,851.06 did not represent net profit from 35 B ship shafts which were completed and delivered, but did actually represent gross manufacturing profit, was undisputed. There is sufficient testimony in the record to convince us that the income from B ship shafts as determined by the respondent is grossly incorrect. We are also convinced because of the condition of the cost records during the taxable year and the years during which this B ship shaft contract was being executed that the costs and expenses properly appertaining to these two classes of income can not be definitely determined. For 1919 it appears that the respondent apportioned the costs and other expenses, not definitely allocable, on the basis of the percentage of each class of sales to the total sales. In fact that is the method partially pursued by him for the taxable year. Under the circumstances of this case in which the only known factors*3561 are the total sales of each class and the net income of both, it is our opinion that the proper method of arriving at an allocation, is to include in the gross sales the sums received under the B ship shaft contract and supplemental contract of June 10, 1920, and to allocate the total costs to the Government and commercial work on the basis of the percentage which each class of sales bears to the total gross sales. The third assignment of error relates to the refusal of the respondent to determine petitioner's excess-profits tax for the year 1920 under the provisions of sections 327 and 328 of the Revenue Act of 1918. Petitioner contends that it has abnormal conditions affecting both income and invested capital within the taxable year 1920 and that its taxes for that year should be computed under the provisions of section 328 of the Revenue Act of 1918. The respondent, on the other hand, alleges that the petitioner has not suffered any exceptional hardship with reference to its profits taxes so as to entitle it to relief under the provisions of the Act aforesaid. Section 327 of the Revenue Act of 1918 provides: SEC. 327. That in the following cases the tax shall be determined*3562 as provided in section 328: * * * (d) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in *542 section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital, nor (2) in which 50 per centum or more of the gross income of the corporation for the taxable year (computed under section 233 of Title II) consists of gains, profits, commissions, or other income, derived on a cost-plus basis from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. Section 328(a) of the same act provides: In the cases specified in section 327 the tax*3563 shall be the amount which bears the same ratio to the net income of the taxpayer (in excess of the specific exemption of $3,000) for the taxable year, as the average tax of representative corporations engaged in a like or similar trade or business, bears to their average net income (in excess of the specific exemption of $3,000) for such year. In the case of a foreign corporation the tax shall be computed without deducting the specific exemption of $3,000 either for the taxpayer or the representative corporations. In computing the tax under this section the Commissioner shall compare the taxpayer only with representative corporations whose invested capital can be satisfactorily determined under section 326 and which are, as nearly as may be, similarly circumstanced with respect to gross income, net income, profits per unit of business transacted and capital employed, the amount and rate of war profits or excess profits, and all other relevant facts and circumstances. Petitioner was organized in 1898, at which time there was a consolidation between the Leechburg Foundry & Machine Co. and Robinson-Rea Mfg. Co. Both of these companies had been engaged in the same business as that*3564 of the petitioner. No testimony was offered with respect to the nature of the consolidation or the condition of these companies at that time. The abnormalities upon which the petitioner relies are (1) the use of Government facilities without cost to the petitioner; (2) machinery and equipment manufactured by petitioner for its own use, the values of which are not fully reflected in the books of account; (3) ownership of patterns and designs not appearing in its books of account for the year in question; (4) ownership of patents and licenses, not appearing in the books of account. We do not consider that the petitioner has adduced sufficient evidence with respect to the Government facilities used by it and with respect to machinery manufactured for its own use to warrant the Board in holding that these facts in and of themselves constitute a sufficient abnormality to bring the case within the provisions of section 327 of the Revenue Act of 1918. The petitioner has shown, however, that it owns 16,709 patterns and equally as many designs or drawings, and that these patterns cost in the neighborhood of $2,000,000; also that the designs had as great if not a greater value than the*3565 patterns. The testimony shows that the petitioner could not possibly carry on its business without the use of patterns and designs, because without a design or drawing of some description a pattern can not be *543 made and without a pattern it would be impossible to successfully manufacture the company's product. The fact that the company's patents and licenses to manufacture under patents owned by others were of great value and were responsible for considerable of its income in 1920 has been demonstrated in a most satisfactory and most convincing manner. The evidence shows that gross sales of articles patented for the year 1920 were $1,336,139.94 and that the net profit from these sales amounted to $196,071.65. Furthermore, that the patented articles represented 20.57 per cent of the total commercial sales. In our opinion the petitioner has presented sufficient evidence as to the ownership of valuable property in the nature of patterns and designs and patents which value is not reflected in its books of account, and can not be correctly determined, to warrant a finding that the existence thereof created abnormal conditions affecting its capital and income which brings*3566 the petitioner within section 327 of the act and therefore its excess-profits tax should be computed under section 328. Reviewed by the Board. Judgment will be entered under Rule 62(c).