Sprague Elec. Co. v. Comm'r of Internal Revenue, Docket No. 32629.

• Decision Date: 19 September 1961
• Docket Number: Docket No. 32629.
• Parties: SPRAGUE ELECTRIC COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

36 T.C. 1043

SPRAGUE ELECTRIC COMPANY, PETITIONER,
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 32629.

Tax Court of the United States.

Filed September 19, 1961.

[36 T.C. 1043]

Hugh C. Bickford, Esq., Henry II. Elliott, Esq., Nicholas Kapnistos, Esq., and Arthur G. Connolly, Esq., for the petitioner.

Donald W. Geerhart, Esq., Paul G. Wilson, Esq., and Irene F. Scott, Esq., for the respondent.

Petitioner has been an electronic components manufacturer since about 1926. During the years 1941 through 1945 it primarily manufactured condensers, resistors, and filters. Held, on the record presented petitioner has shown that some part of the income received from these items can be attributed to research and development in prior years within the meaning of section 721(a)(2) (C), I.R.C. 1939.

MULRONEY, Judge:

The respondent determined deficiencies and overassessments in income, declared value excess profits tax, and excess profits taxes for the calendar years 1941 through 1945. The petition raised 20 issues on the basis of said determinations. Issues 2 through 20 relating to adjustments of gross income and deductions have been settled and the net tax effect of such settlement has been stipulated by the parties. The deficiencies determined by respondent and the overassessments claimed by petitioner are stipulated to remain in dispute as follows:

+------------------------------------------------------------+
                ¦Year ¦Tax liability¦Tax previously¦Deficiency¦Overassessment¦
                +-----+-------------+--------------+----------+--------------¦
                ¦ ¦ ¦assessed ¦ ¦ ¦
                +------------------------------------------------------------¦
                ¦INCOME TAX ¦
                +------------------------------------------------------------¦
                ¦1941 ¦$108,829.20 ¦$107,375.59 ¦$1,453.61 ¦ ¦
                +-----+-------------+--------------+----------+--------------¦
                ¦1943 ¦74,091.43 ¦360,290.00 ¦ ¦$286,198.57 ¦
                +-----+-------------+--------------+----------+--------------¦
                ¦1944 ¦75,958.18 ¦463,020.39 ¦ ¦387,062.21 ¦
                +-----+-------------+--------------+----------+--------------¦
                ¦1945 ¦88,874.43 ¦265,748.52 ¦ ¦176,874.09 ¦
                +-----+-------------+--------------+----------+--------------¦
                ¦1946 ¦296,864.29 ¦345,352.54 ¦ ¦48,488.25 ¦
                +-----+-------------+--------------+----------+--------------¦
                ¦Total¦644,617.53 ¦1,541,787.04 ¦1,453.61 ¦898,623.12 ¦
                +------------------------------------------------------------+
                

DECLARED VALUE EXCESS PROFITS TAX
                1942 $8,224.77 $8,591.54 $366.77
                1944 50,407.12 47,232.45 $3,174.67
                1945 6,946.50 6,946.50
                Total 65,578.39 55,823.99 10,121.17 366.77
                

EXCESS PROFITS TAX
                1941 $84,508.09 $79,820.82 $4,687.27
                1942 520,726.14 525,397.54 $4,671.40
                1943 1,117,163.37 477,430.30 639,733.07
                1944 1,741,240.36 1,223,339.66 517,900.70
                1945 1,790,791.52 1,270,862.85 (1)
                Total 5,254,429.48 3,576,851.17 1,682,249.71 4,671.40
                Grand total 5,964,625.40 5,174,462.20 1,693,824.49 903,661.29
                Net deficiency without regard to section 721, I.R.C. 1939 790,163.20
                

In 1929 the petitioner removed from Quincy to a larger plant in North Adams, Massachusetts, and the new plant was opened in January 1930. The heavy expense of relocation was financed with borrowed funds. By the end of 1931 the petitioner was in financial difficulties, and on December 7, 1931, petitioner and its creditors executed a creditors' agreement which provided, in part, that the creditors were to appoint the treasurer for the petitioner, that a committee of four should be appointed to ‘exercise entire supervision over the affairs of the Debtor,‘ and that the petitioner should undertake no new lines of manufacture or production in addition to its condenser business without the consent of the committee. These creditors were paid off in full by the petitioner by October 1937, and the creditors' agreement was terminated as of that date.

Petitioner's net sales and net income before provision for Federal income taxes for the years 1932 through 1938 were as follows:

+--------------------------------+
                ¦Year ¦Net sales ¦Net income ¦
                +------+------------+------------¦
                ¦1932 ¦$671,266.27 ¦($94,574.00)¦
                +------+------------+------------¦
                ¦1933 ¦1,156,736.17¦11,268.80 ¦
                +------+------------+------------¦
                ¦1934 ¦1,475,803.27¦118,684.56 ¦
                +------+------------+------------¦
                ¦1935 ¦2,058,660.20¦282,773.66 ¦
                +------+------------+------------¦
                ¦1936 ¦2,903,492.48¦317,747.83 ¦
                +------+------------+------------¦
                ¦1937 ¦2,657,785.07¦196,999.81 ¦
                +------+------------+------------¦
                ¦1938 ¦1,864,941.16¦55,708.30 ¦
                +--------------------------------+
                

From about 1932 to 1936 the petitioner assigned Robinson, with a reduced research staff, to work with the manufacturing division on ways to reduce costs and improve the products manufactured by the petitioner obtained permission from its treasurer, who had been appointed by the creditors' committee, to release Robinson and his research group from their production responsibilities.

[36 T.C. 1048]

Robinson, with additions to his staff, was then free to work on new products. Notebooks were issued to the research staff and the results of research and experimentation were recorded there.

Starting in 1936 the petitioner's research group worked on oil impregnants for condensers, which included mineral oil, castor oil, and an oil called Vitamin Q; filters; energy storage condensers used in networks; resistors; Selkar condensers; and transmitting mica condensers.

In the small paper tubular condensers manufactured by the petitioner prior to 1936, two or more layers of paper were wound in a tubular form with interleaved layers of aluminum foil, and the whole unit was impregnated with wax or cable oil. The aluminum foil served as the electrode while the paper and the impregnant served as the dielectric. In the paper spacing between the electrodes, impurities are fatal to a condenser and consequently the wound unit must be placed under vacuum to remove the air and the impregnant is then forced into the tube under pressure to remove the impurities and fix the characteristics of the condenser. The wax used in the early tubular condensers as a dielectric impregnant was paraffin wax, which had a dielectric constant of 2, the unit being measured against air which has a dielectric constant of 1. Later, a substance with the trade name of Halowax, with a dielectric constant of 4, was used in wax impregnated with small tubular condensers. These wax impregnants were limited to low voltages and low temperatures, and where higher temperatures and voltages were required, the impregnant used was cable oil.

In the early 1930's the General Electric Company developed a new impregnant identified chemically as chlorinated diphenyl and sold under the trade name of Pyranol. This preempted the field in markets requiring high temperatures and voltages, such as fluorescent lights, motor applications, and industrial oil condensers. Since it had a dielectric constant over 4 it could produce the same capacity as cable oil in about one-half the size. It opened a wide field in larger condensers, commonly called industrial oil condensers, which the petitioner had not manufactured prior to that time.

In 1933 the petitioner sought to obtain a license from the General Electric Company to use Pyranol, but certain price controls required by General Electric Company were unsatisfactory to petitioner and no license agreement was executed. Three years later the General Electric Company removed the objectionable features from its licenses, and the petitioner again attempted to get a license but was informed that no new licenses were being issued.

Petitioner's research group, which was then assigned the problem of developing impregnants which would enable petitioner to compete with Pyranol, was unable to accomplish this result with a single impregnant

[36 T.C. 1049]

but eventually developed three separate impregnants which covered the field preempted by Pyranol. These were a mineral oil impregnant, a castor oil impregnant, and an impregnant with the trade name of Vitamin Q.

Petitioner concentrated on a search for a mineral oil impregnant which would give a long life without lowering the leakage resistance (resistance to leakage of electrical characteristics). Mineral oil had been used in condensers by petitioner and others prior to 1936. Petitioner had used a mineral oil (cable oil with resin) as early as 1930 or 1931. The leakage resistance of these cable oil impregnated condensers was poor at high temperatures, and in 1936 the petitioner established that this was due to the resin content.

By July 1937 the petitioner found two mineral oils without resin that would give a satisfactory performance at high temperatures and also had satisfactory lasting qualities. These mineral oils, which were supplied to petitioner by outside sources, were further developed and they were put into production in 1939 in a filter condenser. In 1939 the petitioner found another mineral oil, purchased from the Sun Oil Company and called Sun Triple X, which upon being further refined by the petitioner proved superior as an impregnant to the two oils found in 1937.

Petitioner continued to use cable-oil resin in its condensers for direct current until a new dry process was developed by petitioner that made it possible to use tee new mineral oil impregnants on direct current condensers. By 1942 the new mineral oil had supplanted cable oil and petitioner discontinued the use of cable-oil resin as an impregnant.

Petitioner's work during the period from 1936 through 1939 on mineral oil condensers involved basic chemical research as well as work on new manufacturing processes, and resulted in the following developments: (1) High voltage designs; (2) correlation of mineral oil chemical structure to electrical characteristics; (3) drying procedures for paper; (4) impregnation techniques; (5) leak-proof terminal structures; (6) testing procedures; and (7) development of testing apparatus.

In September 1942 the petitioner investigated the effect of mineral oil on the power factor of...