41 T.C. 292">*292 The issue in this case is excess profits taxes under section 721 1963 U.S. Tax Ct. LEXIS 11">*12 of the Internal Revenue Code of 1939, as amended, ¹ for the calendar year 1942. The principal questions are the existence of "net abnormal income" in such year, and the portion thereof attributable to other taxable years under section 721(b).

On November 21, 1961, we filed our Findings of Fact and Opinion herein, 37 T.C. No. 30. We decided in such report that petitioner had realized "Abnormal Income" within the meaning of section 721(a)(2)(C); 41 T.C. 292">*293 assumed the existence of "Net Abnormal Income" under section 721(a)(3) for such year; but concluded that none of it could be attributed to any other year under section 721(b) and section 35.721-3, Regs. 112, because we had been afforded no reliable or acceptable basis or method for screening out World War II induced increased demand for petitioner's product.

On further consideration we concluded that the substantial sums which had been expended by petitioner1963 U.S. Tax Ct. LEXIS 11">*13 in exploration and development work in prior years had resulted (in and of themselves, and apart from war-induced increased demand and improvement in business conditions) in increased abnormal income for petitioner in 1942, and that the method we now employ would effectively eliminate that portion of such abnormal income which is attributable to war-induced increased demand; consequently we withdrew the said report of November 21, 1961, and have by appropriate orders admitted further evidence into the record and received further briefs from the parties.

FINDINGS OF FACT

Some of the facts are stipulated and are so found.

At all times material, Climax Molybdenum Co., hereinafter called Climax, was a Delaware corporation. From about 1933, its principal office was located in New York, N.Y. Its corporate existence continued until December 30, 1957.

Petitioner is a New York corporation organized on June 17, 1887, with its principal office in New York, N.Y. Prior to December 30, 1957, petitioner's name was The American Metal Co. (Ltd.). As of such date, petitioner and Climax were consolidated and merged, with the petitioner continuing as the surviving corporation. Thereupon, petitioner1963 U.S. Tax Ct. LEXIS 11">*14 changed its name to American Metal Climax, Inc.

By order, dated February 13, 1959, petitioner was substituted for Climax, which filed the original petition herein.

Climax was organized on January 17, 1918, to acquire certain mining claims held by E. C. Heckendorf and others on the molybdenite property located on Bartlett Mountain near Climax, Colo.

At all times material, Climax employed an accrual method of accounting and filed its tax returns thereunder and on a calendar year basis. Its tax returns were filed with the collector of internal revenue for the third district of New York.

Climax filed its excess profits tax return for 1942 on March 15, 1943. The total net assessment of excess profits tax against Climax for 1942 was $ 4,409,066.94. The entire amount of such net assessment was discharged prior to February 6, 1946, by payment or by credit of other amounts due Climax.

41 T.C. 292">*294 On February 6, 1946, Climax filed a claim for refund of excess profits tax (Form 843) with respect to the calendar year 1942 in which it claimed the benefit of section 721 of the 1939 Code and asserted that the net amount of tax to be refunded was $ 2,391,636.93. Thereafter, Climax filed two supplemental1963 U.S. Tax Ct. LEXIS 11">*15 documents in support of its claim for refund. The first document, designated a protest, was filed on May 19, 1950. The second document, filed on September 14, 1954, took the form of a letter purporting to amend the original claim for refund in certain respects, including the submission of revised and additional data. Climax's claim was disallowed in full on March 8, 1955.

Climax's mine is located on Bartlett Mountain approximately 100 miles west of Denver, Colo., and is about 1 mile east of the Continental Divide. Outcroppings of molybdenite, the ore mineral of molybdenum, occurred on the southwestern slope of the mountain. The existence of these outcroppings had been known for some time before Climax was organized. Climax, after taking over the claims in 1918, operated the mine until 1919, at which time the mine was shut down because of the lack of demand for molybdenum. Operations were resumed in August of 1924 and have continued to the date of trial.

Molybdenum is an alloying metal and is element No. 42 of the Chemical Periodic Table. There are two major types of molybdenum deposits in the world. In the first, molybdenum occurs as the main product, while in the second 1963 U.S. Tax Ct. LEXIS 11">*16 molybdenum occurs as a recoverable byproduct from copper operations. The Climax mine is of the first type and is the world's largest single primary source of molybdenum.

In the Climax mine, numerous siliceous veinlets impregnated with molybdenite had penetrated the granite rock. This molybdenite, a compound of molybdenum and sulfur, contained approximately 60 percent molybdenum. The ore that outcropped on the surface also extended a considerable depth below the surface. In the upper 700 feet, the ore body was quite symmetrical and surrounded a dome-shaped cone of high silica rock that gradually enlarged below the surface. At deeper levels, the symmetry of the ore body was destroyed by another intrusion of mineralization. The ore body was low in its content of molybdenite varying from zero to slightly more than 1 percent. The overburden or waste that covered the ore body was of two types, glacial debris and low-grade material of uneconomic mineralization. Climax recovered about 18 pounds of molybdenite from a ton of ore assaying 1 percent. This amounted to about 11 pounds of molybdenum.

The first mining by Climax occurred on the Leal Level at an altitude of 12,145 feet on Bartlett1963 U.S. Tax Ct. LEXIS 11">*17 Mountain. In 1927, the last tonnage was hauled from Leal Level as the higher grade ores had been extracted. Operations were then shifted to the White Level which was 41 T.C. 292">*295 205 feet below the Leal Level and more productive. In 1929, Climax began development work at the Phillipson Level of its mine which was about 470 feet below the White Level. The first production from the Phillipson Level, other than that produced during the course of development work, referred to as "development tonnage," was during May 1933. Production from the White Level ceased in September of 1937. From the latter date through 1942, production was from the Phillipson Level, except for small stipulated amounts of development tonnage in 1941 and 1942 from levels below the Phillipson. Through the year 1942, Climax carried on no other mining operations and the only metal recovered from its mine was molybdenum.

The grade of the ore body that Climax considered economical to mine varied over the years. In the late 1920's and the early 1930's the grade limit was ore containing six-tenths of 1 percent molybdenite. In the middle 1930's, the cutoff grade was reduced to 0.45 percent. Later in the 1930's, it1963 U.S. Tax Ct. LEXIS 11">*18 was further reduced to 0.4 percent, where it remained substantially throughout the 1940's.

Climax employed two types of mining. On the Leal Level and to a lesser extent on the White Level, it used a gloryhole type of mining, and it also used shrinkage stopes and open-room and pillar methods. As its mining progressed to deeper levels, Climax needed a more economical method of mining that would permit the extraction of low-grade ores in large volume. Accordingly, it adopted the block or progressive caving method of mining, which was the most economical method of mining this particular ore body. The progressive caving method utilized gravity to break up the ore as contrasted with drilling and blasting. Numerous joints and fractures in the rock assisted in breaking up the mass when it subsided. Essentially, the progressive caving method contemplated driving in from the surface beneath the ore body to be mined, removing the supports from underneath the column of ore to be recovered by an intricate system of undercutting on a level that would cause subsidence, and thereafter extracting the ore from underneath. The ore was removed from the mine in ore trains through haulage drifts. 1963 U.S. Tax Ct. LEXIS 11">*19 The overburden or waste followed the ore down after caving diluting it from 10 to 20 percent.

Climax employed two methods of caving, the "grizzly" system and the "slusher" system. The grizzly system was used on the White Level and on the Phillipson Level prior to November 1936. Thereafter, a combination of the grizzly and slusher systems was used on the Phillipson Level. On levels below the Phillipson Level, the slusher system was used. The slusher system had several advantages over the grizzly system, including safety, better ventilation, cheaper development costs, and greater productivity. The main hazards of both systems 41 T.C. 292">*296 were dust and falls. Also there were hangups at points which required blasting.

In the grizzly system of progressive caving, a vertical chute for control of the ore was raised from the haulage level. Branch raises led off from this chute to a sublevel, known as the "grizzly level," which was about 60 feet above the haulage level, and on which rooms were located called "grizzly chambers." From the grizzly chambers, finger raises at a 45 o angle were driven upward about 50 feet into the undercutting level where the undercuts were connected together1963 U.S. Tax Ct. LEXIS 11">*20 in such a way as to leave pillars supporting the ore above. The intervening pillars were then longholed and blasted with the result that the ore passed down the finger raises to the grizzly level where its flow into the branch raises and the chute could be controlled.

In the slusher system a slusher drift was driven above and at right angles to the haulage drift. From the slusher drifts, about 100 feet long in each direction, finger raises were driven up into the undercutting level in a similar manner to the grizzly system. Again, the undercuts were joined together in a way which formed the pillars. When the supporting pillars were blasted, the ore subsided into the finger raises and then down to the slusher drift. Scrapers were employed at this drift to scrape the ore into the ore cars on the haulage level below. The distance between the haulage level and the undercutting level in the slusher system was about half that of the grizzly system.

The rock containing the ore was removed from the Phillipson Level by ore trains and transported to Climax's mill located approximately one-half mile from the mouth of the level. The low grade of the ore prohibited hauling the rock any 1963 U.S. Tax Ct. LEXIS 11">*21 great distance. The rock had no salable value at the mine portal.

At the mill, Climax concentrated or upgraded the mineral in the rock to make it salable. No other change was made in the mineral as the result of the milling process. The rock reached the mill in all shapes and sizes. The first step in the milling process was to crush the rock with primary and secondary crushers until it passed through vibrating screens with 1/4-inch openings. After crushing, the material went to cylindrical drum-type mills, half full of steel balls, where it was ground to a fineness that would pass through a 100-mesh screen (10,000 openings per square inch). The material was then mixed with water and certain chemical reagents and passed through a rough flotation circuit wherein the mineral floated off from the rock. At this stage in the milling process, the mineral content had been upgraded from about one-half of 1 percent to 10 percent molybdenite. The tailings or waste, which contained small amounts of molybdenite, were discharged from the mill through pipes to the tailings ponds. 41 T.C. 292">*297 The amount of molybdenite remaining in the tailings depended upon the fineness of the grind in separating1963 U.S. Tax Ct. LEXIS 11">*22 the molybdenite from the rock.

Subsequent milling steps were all designed to upgrade the 10-percent concentrate until a salable product was reached. These consisted of progressively finer crushing or grinding and flotation through three or four stages until a concentrate consisting of 90 to 92 percent molybdenite was reached, the remainder being small quantities of iron, copper, tungsten, and rock material of quartz and feldspar. This was essentially the milling procedure followed by Climax during the years 1938 through 1942. The slight variations in grade of ore during these years did not materially affect the cost of milling.

In 1918, when Climax acquired the mining claims, little was known of the extent or depth of the ore body. Over the years, Climax conducted exploration of the mine mainly by diamond drilling for the purpose of determining the size, shape, location, and grade of the ore bodies and zones. Exploration of what later became the Phillipson Level began in August of 1926 and was completed in January of 1930. Climax maintained records of its diamond drillings which showed the location of each hole, the core removed therefrom, and the results of assays made of such1963 U.S. Tax Ct. LEXIS 11">*23 core. An analysis of these drilling records from 1926 through 1942 indicates that holes drilled during the period 1926 through January 1930 were for exploration purposes, that holes drilled to levels below the Phillipson Level through 1942 were also exploratory, but that holes drilled after January 1930 on the Phillipson Level were for development purposes. Development drilling was aimed at defining the tonnage and the grade of the ore over individual work places or draw points.

Development work generally followed exploration. It consisted of all the work necessary to prepare the ore body for production beginning with the driving of an adit or tunnel into the mountain below the ore body and included the drifting, raising, and the undercutting necessary to remove the support of the ore above it. Upon the blasting of the support pillars, the development work of the area in question was completed and the draw point was turned over to the production crews.

In 1929, development of the Phillipson Level was begun by starting an adit or tunnel from the surface to the mineralized zone on that level and by starting an inclined shaft from the surface to such level. Various drifts, raises, 1963 U.S. Tax Ct. LEXIS 11">*24 chutes, chambers, ore passes, undercutting, and other work necessary for production from the ore body were completed and the first production from the Phillipson Level, after blasting and subsidence, was obtained in May 1933. Thereafter, as the workings on the Phillipson Level progressed, additional subsidence occurred. 41 T.C. 292">*298 Without this development work, production in the taxable year would have been impossible.

In the manufacture of steel there are frequently added alloying elements or agents to obtain certain effects either in properties, behavior, or processing. Such steel is referred to as alloy steel. The more commonly used alloying elements are chromium, manganese, molybdenum, nickel, silicon, tungsten, and vanadium. The major categories of steels in which alloying elements are used are engineering steels, corrosion-resistant or stainless steels, high-temperature steels, tool and die steels, and electrical steels. By far the largest tonnage of alloy steels is the engineering steels. Chromium, nickel, manganese, and molybdenum can all be used in the first four categories of alloy steels. Silicon is used mainly in electrical steels, but has some application in engineering1963 U.S. Tax Ct. LEXIS 11">*25 and tool and die steels. Tungsten is used mainly in tool and die steels and in high-temperature steels, while vanadium is used in engineering, tool and die, and high-temperature steels.

In manufacturing alloy steels, the alloying elements are added while the steel is molten. The addition of molybdenum creates a number of effects, including "hardenability" or increased strength and high melting point with consequent heat resistance. Molybdenum also has a pronounced effect in increasing the resistance to corrosion. It improves the hardness or hot strength of steel, and under a number of conditions it improves the toughness of steels. In many alloy steels, molybdenum and one or more other alloying elements are used to secure the quality of steel desired. In the engineering steels, which have by far the largest tonnage of the alloy steels, chromium, manganese, and nickel are also used to increase the hardenability of the steel. Chromium and nickel were used as alloying elements prior to 1900. Manganese first came to be used between 1900 and 1910. Although there was some use of and demand for molybdenum during World War I, it first gained notable acceptance between 1920 and 1925. 1963 U.S. Tax Ct. LEXIS 11">*26 Prior to this period, molybdenum was considered a rare element, there was very little of it, and it was costly.

In making engineering alloy steels, the steel industry in this country selected the alloying elements that would provide the desired properties most economically. In 1900, the only elements used in engineering steels were nickel and chromium. Between 1900 and 1920, vanadium and chromium-vanadium steels were being used with proportionately fewer of the nickel steels. Molybdenum first gained acceptance in 1920 and thereafter increased rapidly at the expense of other alloying elements. The main reasons for the growth of molybdenum in engineering steels were that it did the job better at a given cost than the other elements, it was available, and it was not lost during melting but could be recovered in scrap. Between 1920 and 41 T.C. 292">*299 1940, the growth of molybdenum as an alloying element in engineering steels was much greater than the growth of such steels themselves.

In corrosion-resistant or stainless steels, molybdenum was mainly of use where severe corrosion conditions existed, such as in the chemical and the pulp and paper industries. Molybdenum was essential in1963 U.S. Tax Ct. LEXIS 11">*27 low-alloy high-temperature steels in that it imparted strength and resistance to embrittlement. It could also be used in other types of high-temperature steels.

Prior to, during, and after 1942, there were three categories of tool and die steels; namely, coldwork steels, hotwork steels, and high-speed steels. Molybdenum was frequently used in the first two categories and became one of the most extensively used elements in high-speed steels. Historically, tungsten was the alloying element most commonly used in hotwork and high-speed steels. By 1905, a high-speed steel known as 18-4-1 (18 percent tungsten, 4 percent chromium, and 1 percent vanadium) had become the established standard all over the world. Tungsten became established first because it was more readily available than molybdenum and worked better in the primitive heat-treating or hardening furnaces then available. During these early years, various molybdenum alloys were tested, but the lack of supply and the unsatisfactory results deterred additional work. In 1932, the first modern molybdenum high-speed steel was introduced; it was cheaper by the pound and produced 8 to 10 percent more tools than the tungsten type. 1963 U.S. Tax Ct. LEXIS 11">*28 Shortly thereafter, one or two steel tool companies introduced a second type molybdenum high-speed steel which, however, was a specialty type unsuitable for heat treatment or hardening in the average toolshop. In 1938, a general-purpose molybdenum high-speed steel was introduced which could be treated or hardened in any type of heat-treating shop without special precautions. Also toward the end of the 1930's, a chromium-molybdenum type of high-speed steel was developed which became a popular type of high-speed steel. In performance, these molybdenum steels were equal to the tungsten type and were cheaper. The changeover from tungsten to molybdenum steels occurred gradually over a period of years, and today molybdenum high-speed steels account for about 85 percent of the high-speed steels produced and sold in this country. Climax contributed to the development of the various molybdenum steels to the extent of providing an assured supply and maintaining a steady price for molybdenum.

Molybdenum has come to be one of the standard alloying elements used in cast and wrought steels. Here, as with alloy steels, it was a latecomer among the alloying elements. It was also widely used1963 U.S. Tax Ct. LEXIS 11">*29 in gray iron, a form of cast iron. Here again, historically, nickel became established first, while molybdenum was first used very experimentally 41 T.C. 292">*300 in the late 1920's. Its use in gray iron increased steadily thereafter as it was available and did the job easier and more economically than any of the other alloying elements.

Molybdenum was also used in the nonferrous alloy field, as metallic molybdenum, which field developed during the 1920's when molybdenum was available. Prior to 1941, molybdenum was also used in significant amounts in the chemical industry as catalysts, pigments, and reagents.

Prior to 1941, the aforementioned industrial fields were the principal consumers of molybdenum. Although molybdenum competed with the other alloying elements for use in these fields, it was also used together with such other alloying elements to secure properties in steel unobtainable by the use of only one element. The growth or increased use of molybdenum in these fields was mainly attributable to the following factors: Molybdenum was an American alloying element; there was an assured supply; the price was steady; and it was simple to use and did the required job.

The main contribution1963 U.S. Tax Ct. LEXIS 11">*30 made by Climax to the growth in use of molybdenum through the taxable year 1942 was the establishment of an assured supply of the element. The exploration and development of the Climax mine prior to and during 1942 established the existence of ample supplies of molybdenum. The establishment of an assured supply made possible a steady price for molybdenum. It was the policy of Climax not only to keep the price of its molybdenum steady but also to effect reductions in price if it would further the use of molybdenum.

During the period 1936 through 1942, Climax contributed to the increased use of molybdenum by disseminating technical information derived from research by steel companies and metallurgical laboratories in this country and abroad. By making molybdenum available to American industry in the form of converted products, it also increased the use of molybdenum in this country. During the period 1936-39, Climax made certain improvements in these converted products which made them cheaper to use by industry in this country. Climax held no patents on molybdenum-type steels.

By the end of 1939, the use of molybdenum by the steel, iron, and chemical industries in this country1963 U.S. Tax Ct. LEXIS 11">*31 had not reached its full development, but there were no major metallurgical or technical problems with respect to molybdenum remaining to be solved. By the end of 1939, increased domestic sales of molybdenum were indicated by its growing use in various industries, but reduced foreign sales were indicated by the outbreak of World War II and Climax's acceptance 41 T.C. 292">*301 in December 1939 of the moral embargo on shipments to Russia, Germany, and Japan.

The producers of molybdenum in this country in competition with Climax through 1942 were the Molybdenum Corp. of America at its Questa mine in New Mexico; the Kennecott Copper Co. in its byproduct production from its copper mines in Utah, New Mexico, and Nevada; and the Miami Copper Co. in its small byproduct production in Nevada. The byproduct production of molybdenum was geared entirely to the production of copper. The biggest source of molybdenum outside of the Climax mine was in the copper deposit of the Kennecott Copper Co. A large part of this byproduct molybdenum was shipped abroad. Molybdenum from the Climax mine had one advantage over byproduct molybdenum in that it contained less copper. The presence of copper limited the1963 U.S. Tax Ct. LEXIS 11">*32 use of byproduct molybdenum in high-speed and stainless steels. Competition to Climax from byproduct molybdenum began in the middle 1930's and thereafter became increasingly severe. This molybdenum cost less to produce than that of Climax. There was no decrease in competition from this source in 1942.

The Molybdenum Corp. of America maintained a conversion plant at Washington, Pa., where it converted its own concentrates and those of Kennecott Copper Co. into finished products. During 1942, the competitive situation between Climax and the other producers and between molybdenum and the other alloying elements remained unchanged. The demand for molybdenum and the other alloying elements in 1942, however, was such that the world production of tungsten, chromium, nickel, vanadium, and molybdenum, and the domestic production of alloyed steels, exceeded the production of any prior year.

Climax maintained a series of accounts in which it recorded certain expenditures in connection with its mine. It was the regular practice of Climax to prepare summary statements in which all the expenditures classified by it as "Development Cost" were accumulated. These statements included preparation1963 U.S. Tax Ct. LEXIS 11">*33 work preceding actual mining and were cut off at, and did not include "Stoping." The titles of these accounts and a brief description of the type of work charged to each by management follow:

Raising. -- All inclined openings advancing upward, such as chute raises, service raises, ore passes, ventilation raises, and miscellaneous raises.

Drifting. -- Haulage drifts, grizzly drifts which served grizzly chambers, slusher, ventilation, and miscellaneous drifts.

Sinking. -- The inclined shaft, previously mentioned, from the surface to the Phillipson Level.

41 T.C. 292">*302 Chutes. -- Used in controlling flow of rock from chute raises into ore cars.

Grizzlies. -- Chambers on the grizzly level for sizing ore before transfer into chute raises.

Loading platforms. -- Openings directly over haulage drifts in slusher system.

Concrete. -- Lining of slusher drifts and grizzly chambers with concrete, 1940 to 1942, inclusive.

Phillipson Tunnel. -- Adit or tunnel, previously mentioned, from surface to mineralized zone.

Stoping. -- All work beginning with driving of finger raises into lower part of undercutting area, the undercutting, the longholing, and the blasting1963 U.S. Tax Ct. LEXIS 11">*34 of the pillars.

Over the years it has been the policy of Climax first to determine the long-range scope of its reserves of ore, both as to tonnage and grade, and then to develop these reserves for a reasonable period ahead. As far as possible, Climax sought to keep the productive capacity of the mine in balance with the capacity of the mill to concentrate the ore. From the middle 1930's through 1942 the mine was usually behind the capacity of the mill to concentrate the ore. Prior to December 1941, the development work at Climax contemplated the maintenance of an efficient operation and a steady growth in business; such development work was not in anticipation of World War II.

In April 1941, pursuant to a request from the Office of Production Management that production be increased to maximum as soon as possible, Climax scheduled an operating program which provided for average daily tonnages of 12,500 tons on May 1, 1941, 13,500 tons as of September 1, 1941, and 15,000 tons as of March 1, 1942. For the years 1938, 1939, and 1940, the average daily number of tons mined and milled, based on a 365-day year, were: 1938, 11,903 tons; 1939, 9,400 tons; and 1940, 10,503 tons. Similarly, 1963 U.S. Tax Ct. LEXIS 11">*35 for 1941 and 1942, Climax mined and milled 12,954 tons and 16,664 tons, respectively.

In producing the 1942 tonnage, Climax increased its mining in the areas of the mine where the better grade ores were located. For some time in the operation of its mine, Climax had been attempting to establish a system of draw control over the various draw points in an effort to limit dilution of the ore by the waste overburden. In 1939, Climax was working to make its draw control measures more effective, that is, draw the top of the ore body down in such a gradual manner as not to pull dilution heavily into any one draw point. In 1941, the draw control measures were being relaxed because of the pressure for increased production, and in 1942, there was very little semblance of draw control. With the relaxation of draw control, dilution of the ore body increased as waste material funneled down to the heavily drawn draw points. This dilution, together with increased mining of its higher grade ores, had the effect of reducing the average grade of the ore reserves at the Climax mine.

41 T.C. 292">*303 In its 1942 milling operation, Climax obtained a higher output by coarsening the grind at the primary grinding1963 U.S. Tax Ct. LEXIS 11">*36 stage. This permitted a greater tonnage of ore to pass through the mill but reduced the mill's percentage of recovery. When operating with the mill and mine in balance, the most economical grind was 36 to 39 percent on a 100-mesh screen, but in 1942 the mill operated on a grind of 40 to 44 percent. By using a finer grind, Climax would have recovered, under normal operating conditions, approximately 3 percent more concentrate in 1942 than it actually obtained. In terms of 1942 production, this represented a loss through coarser grinding estimated at approximately 1,200,000 pounds of molybdenum.

The capacity of the Climax mine to produce ore as of any time was dependent upon the prior exploration and development work. As a general proposition, its maximum capacity tended to be directly proportional to the total number of workplaces available for draw at any given time. At December 31, 1942, Climax had 299 draw points in existence, 159 using the grizzly system of drawing ore and 140 using the slusher system. In 1942, the mine and the mill were capable of producing approximately 30 million pounds of molybdenum without violating good mining practices, but in 1942 said practices 1963 U.S. Tax Ct. LEXIS 11">*37 were violated in order to achieve maximum production.

Climax maintained a townsite in close proximity to its mine consisting of a store, houses, and other facilities for its employees. It was built for the purpose of securing and retaining employees at this undesirable and inhospitable location.

The molybdenum concentrates produced by Climax contained sulfur which curtailed their sale in the United States. The sulfur was removed by roasting the concentrates in a multiple-hearth roaster. Prior to 1937, Climax removed the sulfur from the concentrates in a conversion plant located at Langeloth, Pa. As of January 1, 1937, Climax organized a wholly owned subsidiary corporation known as Climax Molybdenum Co. of Pennsylvania. Under date of February 7, 1937, Climax contracted with its Pennsylvania subsidiary to do the necessary smelting and converting of its molybdenum concentrates into molybdenum products which could be used by purchasers in this country most of whom, unlike European purchasers, lacked smelting and converting facilities.

During the years involved herein, Climax considered itself a mining company. It conducted the conversion operations because it hoped by such operations1963 U.S. Tax Ct. LEXIS 11">*38 to further the use of molybdenum by making available in this country converted products which industry could use without any additional smelting or converting.

A summary of Climax's sales of molybdenum, in thousands of pounds and dollars, for the years 1924 through 1942, with a breakdown 41 T.C. 292">*304 for the years 1931 to 1942, inclusive, between domestic and foreign sales, follows:

1963 U.S. Tax Ct. LEXIS 11">*39 A breakdown of Climax's dollar sales between domestic and foreign sales of converted products and concentrates for the years 1931 to 1942, inclusive, follows:

In August of 1931, Climax organized a wholly owned subsidiary corporation known as Climax Molybdenum Co. of Michigan. This subsidiary, under a contractual arrangement with Climax, engaged in research and other experimental work in Detroit, Mich., through and beyond December 31, 1942. Under its contract the subsidiary agreed that it would --

1. * * * devote all of its business 1963 U.S. Tax Ct. LEXIS 11">*40 activities in carrying on research and experimental work in the interest and for the sole use and benefit of the Climax Company and that it will undertake and prosecute all such experiments and work in connection with enlarging and perfecting the use of molybdenum as an 41 T.C. 292">*305 alloying element in the manufacture of steel or otherwise as the Climax Company shall from time to time designate or desire undertaken in connection with such other experiments along the same or other lines as the Michigan Company shall find advisable or consider as likely to be beneficial after consultation with and the approval of the Climax Company.

In full payment for these services, Climax agreed to reimburse the subsidiary for all of its costs of operation plus 10 percent as profit, to sell to it all molybdenum products it desired at 5 percent below current or list prices, and to advance without interest all sums needed in the conduct of its business.

For many years Climax's Michigan subsidiary maintained a laboratory at Detroit, Mich. Its equipment consisted principally of testing equipment, tensile and hardness machines, and small heat-treating furnaces. In 1935, a furnace of 500 pounds' capacity1963 U.S. Tax Ct. LEXIS 11">*41 was installed. The laboratory supplemented the efforts of the engineers in the district offices by providing technical services and testing services free of charge to iron foundries. The laboratory maintained by Climax's Michigan subsidiary was small in comparison to those of the major steel companies.

During the period here involved, the laboratory also carried on research activities and published technical articles from time to time. These activities included fundamental research into what happens to steel during heat treatment, and why it happens. The laboratory also spent considerable time in the attempted development of a molybdenum high-speed steel containing copper and boron. Prior to 1942, the activities of the laboratory developed no new commercial alloy steel. During 1942, the laboratory was engaged mostly in war projects, such as trying to make ductile chromium and development of new heat treatments for armor-piercing shot.

Before and during the period from 1938 through 1942, Climax maintained district offices throughout this country. There were offices in the cities of Pittsburgh, Detroit, Chicago, Denver, and Los Angeles, and in the State of Ohio. These offices1963 U.S. Tax Ct. LEXIS 11">*42 were headed by graduate engineers most of whom had had practical experience in some field of the steel or iron industry. There was also a metallurgical engineer in Climax's main office in New York. Each office had jurisdiction over a particular part of the country. The duties of these engineers were to promote increased uses for molybdenum and to create new usages for the metal. This was done by calling on metallurgists for the steel companies, iron foundries, and their customers and steel warehouses.

The district offices employed no salesmen as such, and the engineers were not permitted to call upon or entertain purchasing agents. The engineers were not permitted to recommend the usage of molybdenum where it neither improved the end product nor reduced the cost of 41 T.C. 292">*306 it to the consumer. Climax followed the policy of selling molybdenum purely on its merit, and during the years 1938 through 1941 it used the slogan "A Little Does a Lot." In 1942, this slogan was not used. During 1942, the engineers in the district offices were all concerned one way or another with warwork; and the demand for molybdenum was such that promotional activities were unnecessary.

During the years1963 U.S. Tax Ct. LEXIS 11">*43 1938 through 1942, Climax placed advertising in various technical magazines and journals. Through 1941, most of this advertising was directed to giving examples of successful applications of molybdenum by industry. During 1942, the character of the advertising changed and in the main was concerned with the support of the war effort. These advertisements invited inquiries about molybdenum and some stated that Climax furnished authoritative engineering data on molybdenum applications. Some inquiries were received from iron foundries as a result of this advertising, but it brought few, if any, additional inquiries or orders from steel companies. Such advertising kept Climax's name and product before the public and trade.

In July 1934, Climax began publishing a monthly circular, entitled "The Moly matrix," which was mailed to interested persons in the trade. In the first issue, Climax stated the purpose of the publication as follows:

The intention of the Climax Molybdenum Company in bringing you the information which will be contained in Moly matrix is not merely to call to your attention Molybdenum steels which, if substituted for a competitive steel, will give you comparative 1963 U.S. Tax Ct. LEXIS 11">*44 physical properties at lower over-all cost, but also to make you familiar with the irons and steels, that are made possible by the use of this "most potent alloy," which will serve to produce a better product -- withstand more abuse -- and last longer.

Thereafter, "The Moly matrix" was published monthly until 1941 when publication ceased after the June issue and was never resumed. Most issues carried examples or illustrations of commercial molybdenum applications in the iron and steel industries. Engineers and metallurgists found that "The Moly matrix" issues provided a convenient summary of available information on the various subjects and applications discussed. The influence, if any, that this publication had on sales of molybdenum is unknown.

In 1938, Climax published a book entitled "Molybdenum in Steel" which was a compilation of data on the then various molybdenum steels and their applications. This publication was useful to a metallurgist or heat treater once he decided to make or heat-treat molybdenum steel. Similarly, Climax published various other articles and brochures on molybdenum which were available without charge to interested parties both prior and subsequent1963 U.S. Tax Ct. LEXIS 11">*45 to 1938. It was the practice 41 T.C. 292">*307 of the producers of ferroalloys to publish similar material. Climax did no radio advertising during the period involved herein.

The world production (rounded figures) of molybdenum, tungsten, chromium, nickel, manganese, and vanadium, and the production of molybdenum by Climax, for the years 1929 through 1942, may be summarized as follows:

1963 U.S. Tax Ct. LEXIS 11">*46 For the years 1931 through 1942, the domestic production of steel, which includes the alloy steels, the domestic production of alloy steel, and the combined total production of steel in Germany, the United Kingdom, Canada, Russia, France, and Japan, in thousands of net tons, as compiled by the American Iron & Steel Institute, were as follows:

In 1924, Climax sold its products containing molybdenum at an average price of $ 1.9791 per pound of molybdenum. Between 1924 and 1932 the average price dropped steadily until 1932, when it reached 55.14 cents per pound. Thereafter, the average price increased and stabilized, and during the period 1934 to 1942, inclusive, was never less than 70 cents per pound. In 1942, the prices received 1963 U.S. Tax Ct. LEXIS 11">*47 41 T.C. 292">*308 by Climax for its products were not higher than the average prices received for the same products for the 4 previous years.

For the years 1938 through 1942, Climax's net sales, cost of goods sold including conversion fees, cost of production at Climax, and net taxable income were as follows (cents omitted):

For the years 1938 to 1942, inclusive, Climax's gross profits on sales of its molybdenum concentrates and converted products, as finally adjusted by respondent, included conversion fees paid to its Pennsylvania subsidiary. After excluding such fees, Climax's gross profits were as follows:

1963 U.S. Tax Ct. LEXIS 11">*48 For the years 1938 to 1942, inclusive, Climax's corrected gross profits on sales of concentrates and converted products, as hereinabove set forth, also included its income or loss resulting from the conversion of its concentrates and the sale of the molybdenum contained therein in the form of converted products. The profit or loss from the conversion operation was as follows:

41 T.C. 292">*309 For 1942, petitioner computed its abnormal income and its net abnormal income to be $ 10,891,651 and $ 10,016,556, respectively, based upon the following computation:

1963 U.S. Tax Ct. LEXIS 11">*49 During the period 1929 to 1942, petitioner was engaged in an intensive program of exploration and development. The following table sets forth by years from 1929 through 1942 the total development costs incurred by Climax with respect to the Phillipson Level only of its mine and includes costs incurred for undercutting work classified by Climax as "stoping":

41 T.C. 292">*310 Included in the costs of the development of the Phillipson Level set forth above were certain costs for service raises, ore passes, entries and stations, chutes, concreting, and haulage drifts in the total amount of $ 226,781.87 with respect to draw1963 U.S. Tax Ct. LEXIS 11">*50 points which had been scheduled for construction prior to December 31, 1942, but which were then not yet in existence. The following schedule shows these costs broken down between the years 1929-39, 1940, 1941, and 1942:

In addition to the foregoing amounts, Climax between 1926 and 1942 expended the following sums on its mine with respect to exploratory diamond drilling:

Of these amounts, $ 3,966.75 represented1963 U.S. Tax Ct. LEXIS 11">*51 1,040 feet of diamond drilling for the White Level of the mine incurred in 1926 and 1927, and $ 374,571.96 represented 99,400 feet of drilling for levels other than the White and Phillipson. Of this $ 374,571.96, $ 178,852.18 representing 48,149 feet of drilling was expended prior to January 1, 1940, $ 37,979.99 representing 10,257 feet of drilling was expended in 1940, $ 39,270.14 representing 11,076 feet of drilling was expended in 1941, and $ 118,469.65 representing 29,918 feet was expended in 1942. With respect to the Phillipson Level alone, Climax prior to January 1, 1940, expended a total of $ 254,212.13 on exploratory diamond 41 T.C. 292">*311 drilling. For the years 1940, 1941, and 1942, the following amounts were so expended with respect to such level:

All the exploratory and development work on the Phillipson Level as of 1942 made just so many tons of ore available for extraction.

The cost depletion with respect to Climax's mine at Climax, Colo., as reflected by its books and records and the percentage depletion allowed for income tax purposes for the calendar years 1938 through 1942, are as follows: 1963 U.S. Tax Ct. LEXIS 11">*52

For 1941 and prior years, Climax's gross income from the property for purposes of computing percentage depletion was computed by using the average price for concentrates sold. For the year 1942 it was computed on the basis of the use of a market or field price of 75 cents per pound of molybdenum contained in the concentrates. The deduction for percentage depletion as claimed by Climax and allowed by respondent for the years 1938 through 1942 represented no cash outlay by Climax.

Climax's direct costs or expenses, deductible in determining the normal tax net income for the year 1942, through the expenditure of which its abnormal income was in whole or in part derived, were $ 2,056,292.61 computed as follows:

1963 U.S. Tax Ct. LEXIS 11">*53 41 T.C. 292">*312 During 1942 petitioner's relevant abnormal income, loss on conversion operation, excess over 125 percent of prior 4 years' average, direct costs and expenses, net abnormal income, non-war-induced replacement factor (expressed as a percentage), and net abnormal income due to exploration and development attributable to other years were as follows:

Petitioner's gross income for the taxable year 1942 included a separate class of income resulting from exploration and development extending over a period of more than 12 months as described in section 721(a)(2)(C).

The sum of $ 150,000 represents the taxpayer's net abnormal income attributable to exploration 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 total1963 U.S. Tax Ct. LEXIS 11">*54 thereof.

OPINION

Petitioner seeks relief under the Internal Revenue Code of 1939 for claimed net abnormal income in 1942, of the class and as defined in section 721(a)(1), (a)(2)(C), and (a)(3). ²1963 U.S. Tax Ct. LEXIS 11">*55 It relies on exploration 41 T.C. 292">*313 and development expenditures made over a period in excess of 12 months which in 1942 allegedly produced income in excess of 125 percent of income resulting from such expenditures earned in the 4 previous taxable years. Petitioner concludes that it is entitled to have such income attributed to prior years under section 721(b)³ and excluded from the coverage of the excess profits tax pursuant to section 721(c). ⁴

Respondent denies that there1963 U.S. Tax Ct. LEXIS 11">*56 was any abnormal income for the year 1942. He further contends, inter alia, that even if there were any such income, none of it can be attributed to any prior year. He relies upon the statutory purpose, and more specifically upon section 35.721-3, Regs. 112. ⁵ He urges that great weight be given to his regulation because of the legislative history of section 721.

1963 U.S. Tax Ct. LEXIS 11">*57 The World War II excess profits tax was first enacted by the Second Revenue Act of 1940. ⁶ The two prime objectives of this legislation were (1) to raise revenue for the national defense program, and (2) to insure that the rearmament program should not permit either the creation of "war millionaires" or the further substantial enrichment of already wealthy persons (H. Rept. No. 2894, 76th Cong., 3d Sess., pp. 1-2 (1940), 1940-2 C.B. 496).

41 T.C. 292">*314 The classes of income defined as abnormal included six ⁷ separate classes. The common characteristic of each class was that it represented defined income currently received that would have been received in the current year regardless of the presence of World War II. The excess profits tax was designed to tax profits arising from the war effort, and section 721 was inserted as a relief provision to alleviate the impact of the receipt currently of income attributable to events or transactions occurring prior to the imminence 1963 U.S. Tax Ct. LEXIS 11">*58 of the war.

In 1941 Congress amended the 1940 legislation. ⁸Congress realized that it could not foresee all possible hardship cases under the excess profits tax, and sought merely to outline the general nature of types of income for which it wished to afford relief. The Treasury Department and the then Bureau of Internal Revenue were intentionally given wide discretion in promulgating regulations within the spirit of the legislation. The legislative history explains this as follows (H. Rept. No. 146, 77th Cong., 1st Sess., p. 2 (1941), 1941-1 C.B. 550-551):

Experience with excess-profits taxes, both in the United States and abroad, has demonstrated conclusively that relief in abnormal cases cannot be predicated on specific instances foreseeable at any time. The unusual cases that are certain to arise are so diverse in character and unpredictable that relief provisions couched in other than general and flexible terms are certain to prove inadequate.

For these1963 U.S. Tax Ct. LEXIS 11">*59 reasons, the present legislation attempts to provide, both by specific terms and in carefully guarded general terms, a set of flexible rules which should alleviate at least the bulk of the severe hardship cases which may arise. The success or failure of legislation of this type depends, to a considerable degree, upon its intelligent and sympathetic administration. Through its confidence in the experience and ability of the officials of the Treasury Department and the Bureau of Internal Revenue, your committee recommend the present flexible and broad legislation as the most satisfactory method of meeting the contingencies that will arise.

Pursuant to this directive, respondent promulgated the regulation quoted above and it has been upheld many times. Primas Groves, Inc., 15 T.C. 396">15 T.C. 396, 15 T.C. 396">401; Soabar Co., 7 T.C. 89">7 T.C. 89, 7 T.C. 89">97; Steel or Bronze Piston Ring Corporation, 13 T.C. 636">13 T.C. 636, 13 T.C. 636">642.1963 U.S. Tax Ct. LEXIS 11">*60

This case was reopened because the record supports the proposition that the efforts of this petitioner in exploration and development of its mine had made available an adequate supply of molybdenum at a stable price for the first time and that as a result of this, the general use of molybdenum as an alloying element by industry, as a substitute and even as a replacement for other alloys, had been encouraged and had taken place and was continuing, prior to and throughout 1942.

41 T.C. 292">*315 The rate of use of molybdenum had, through the years, increased faster than the rate of increase in use of other alloying elements which were being replaced by molybdenum. If a proper formula, eliminating wartime pressures, could be devised to measure this difference in increased rate of use and the formula applied to the year 1942, then war-induced increase could be strained out of petitioner's income for such year.

The first question is whether petitioner has realized income of a class described in section 721(a)(2)(C). We have found this in the affirmative in our findings and, in language which we here adopt, we noted in the withdrawn opinion that --

Petitioner has made expenditures in the exploration1963 U.S. Tax Ct. LEXIS 11">*61 and development of its mine, especially at the Phillipson Level, without which the increased production of 1942 would have been impossible. Since the terms "exploration" and "development" are not defined in the statute, we must look to their meaning in the mining industry. "Exploration" refers to "The work involved looking for ore," and "development" is defined as "work done in a mine to open up ore bodies, as sinking shafts, driving levels, etc." ⁹ From the facts of this case there can be no doubt that petitioner expended substantial sums on exploration and development work for a period well in excess of 12 months. It therefore has realized income of the class described in section 721(a)(2)(C).

A second question is whether any part of the net abnormal income can be attributed to other years under section 721(b) and section 35.721-3, Regs. 112. In the withdrawn opinion we noted that while some attribution might1963 U.S. Tax Ct. LEXIS 11">*62 be proper, the evidence did not provide a reliable basis for attribution:

Although some small segment of the development expenditures might normally have resulted in increased 1942 production, petitioner's indices do not afford any reliable basis for ascertaining this normal growth * * *

The supplemental evidence has afforded a reliable basis for ascertaining the relevant growth, and therefore, we may properly attribute a portion of the relevant net abnormal income to other years.

It has been found that $ 24,611,848 is the amount of 1942 corrected gross profit on sales. This must be adjusted by the $ 981,294 loss suffered by Climax on the relevant conversion operation, since income or loss from factors not comprehended in section 721(a)(2)(C) must be strained out. The resulting $ 25,593,142 is reduced by 125 percent of the 1938-41 average, or $ 14,701,491, totaling $ 10,891,651. Sec. 721(a)(3)(A).

The $ 10,891,651 is next reduced by a ratio in which the relevant direct costs are comprehended. Sec. 721(a)(3)(B). Petitioner does not dispute the use of cost depletion, and, in interpreting "direct costs 41 T.C. 292">*316 or expenses" as used in section 721(a)(3)(B), we have included 1963 U.S. Tax Ct. LEXIS 11">*63 cost depletion rather than the percentage depletion which respondent asserted. Section 721(a)(3) uses the following terms: "direct costs or expenses, deductible in determining the normal-tax net income of the taxable year, through the expenditure of which such abnormal income was in whole or in part derived." (Emphasis added.) Climax's deduction in 1942 for percentage depletion did not represent an expenditure or cash outlay through which abnormal income was in whole or in part derived. Cf. Sprague Electric Co., 36 T.C. 1043">36 T.C. 1043, 36 T.C. 1043">1086.

Percentage depletion does not involve expenditure or cash outlay, nor is it a cost for accounting purposes. Louisiana Iron & Supply Co., 44 B.T.A. 1244">44 B.T.A. 1244, 44 B.T.A. 1244">1246; Mary F. Waggoner, 47 B.T.A. 699">47 B.T.A. 699. Further, our treatment is consistent with Morrisdale Coal Mining Co., 13 T.C. 448">13 T.C. 448, 13 T.C. 448">452, and section 35.721-1, Regs. 112, example 2. Finally, if Congress had meant to refer to all deductions attributable to abnormal income, it would not, in our opinion, have used the terminology "direct costs or expenses" and "expenditure."

Using1963 U.S. Tax Ct. LEXIS 11">*64 the resulting $ 2,056,293 as the direct cost figure, the relevant ratio totals an $ 875,095 reduction from the $ 10,891,651, and we have found that $ 10,016,556 was the 1942 net abnormal income.

"[Not] unmindful of the difficulties involved," General Tire & Rubber Co., 29 T.C. 975">29 T.C. 975, 29 T.C. 975">988, we have utilized the replacement factor of 0.0156 and, with due regard to Ramsey Accessories Manufacturing Corporation, 10 T.C. 482">10 T.C. 482, we have found that petitioner's net abnormal income for 1942 due to exploration and development and attributable to prior years is $ 150,000.

Reviewed by the Special Division.

Decision will be entered under Rule 50.