Opinion
Docket No. 112051.
1945-03-15
ASSOCIATED PATENTEES, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Howe P. Cochran, Esq., and Margaret F. Luers, Esq., for the petitioners. Jonas M. Smith, Esq., for the respondent.
Four individuals transferred to petitioner certain patents which they jointly owned in equal proportions under a contract obligating petitioner to pay them 80 percent of its income from licenses granted for their use. Under this contract petitioner paid them $42,209.76 in the taxable year and in its return deducted that amount as royalties paid. Held:
(1) This payment was a capital expenditure in acquisition of the patents.
(2) Petitioner is entitled to recover by depreciation its total cost of the patents over their lives and, since such cost is not determinable until the close of the term when all of the value of the patents passes and since the yearly payments are attributable to income of the year in which made, the ‘reasonable allowance‘ for depreciation provided by section 23(1), I.R.C., requires the allowance of a deduction in each year equivalent to the payment made in that year. Such allowance will give petitioner over the term no more than its cost and no distortion of income will result. Howe P. Cochran, Esq., and Margaret F. Luers, Esq., for the petitioners. Jonas M. Smith, Esq., for the respondent.
Memorandum findings of fact and opinion was entered in this proceeding on August 31, 1943. The deficiencies involved arose wholly from the disallowance by respondent of a deduction of $42,209.76 taken by petitioner for the calendar year 1940 as patent royalties paid in that year by it to four individuals. Our conclusion was that this payment was a capital expenditure by petitioner in the acquisition of the patents from those individuals and as such was not deductible. Decision was entered for the respondent.
Thereafter, petitioner filed timely motions to vacate the decision, to reconsider the opinion, and for rehearing or new trial. On October 20, 1943, we entered an order, upon petitioner's motions vacating our decision and opinion theretofore entered, and granted petitioner's motion for rehearing, directing that such rehearing be limited to the question of the depreciation to which petitioner would be entitled in the taxable year in question for exhaustion of its capital investment in view of our holding that the expenditures deducted by petitioner were capital in character. Petitioner, by our order, was permitted to file an amended petition raising the issue as to allowance of depreciation. Such amended petition was duly filed.
The rehearing as directed by our order was held May 8, 1944. Certain evidence was introduced, without objection, bearing upon the question of the value of the patents in question. We make the following findings of fact.
FINDINGS OF FACT.
The petitioner is a business corporation organized in 1933 under the laws of the State of New Jersey. Its principal place of business was in East Orange, New Jersey. Its authorized capital stock consisted of 100 shares of common without par value. All shares were issued. In about 1928 or 1929, Alwyn E. Borton, Frederick Koch, and Walter P. Powers, all inventors and holders of patent rights, together with Cecil Todd, a financier, entered into an oral agreement to pool the patents and inventions on an equal share basis of one-quarter to each. They caused the petitioner to be formed. Each became an officer and director of the corporation. At the first meeting of the directors, held on January 14, 1933, the aforementioned individuals made an offer to sell, assign, and transfer to the petitioner all of their right, title, and interest in and to 20 patents in exchange for the 100 shares of the capital stock of the petitioner. The directors, by resolution, accepted the offer. On January 16, 1933, these individuals executed and delivered to the petitioner a written assignment of 20 patents, designated therein by number, date of issue, and a brief description thereof. Thereupon the petitioner caused to be issued to each of these assignors 25 shares of its capital stock of no par value. On January 16, 1933, the individuals trusteed their respective shares of said capital stock to William Dunkel.
Subsequent to the incorporation of the petitioner, and pursuant to the pooling arrangement, certain other patents were similarly assigned from time to time to the petitioner without fixing the consideration therefor, because it was then impossible to approximate their value, since they had not yet been used commercially.
Under date of October 15, 1934, the petitioner entered into a written agreement with the U.S. Tool Co. which contains, inter alia, the following provisions:
WHEREAS, The U.S. TOOL is desirous of using certain patents, trade marks, etc. now owned by the ASSOCIATED PATENTEES; and
WHEREAS, The ASSOCIATED PATENTEES are willing to grant to the U.S. TOOL exclusive right to use the patents, trade marks, etc. in question;
1. In consideration of the complete payment of all expenses in connection with the obtaining and development of the said patents, trade marks, etc., the ASSOCIATED PATENTEES agree that the U.S. TOOL shall have the exclusive use of the said patents, trade marks, etc. for the period of five (5) years from the date of this agreement subject to the following provisions.
2. It is understood that the U.S. TOOL shall in no way transfer, assign or sell its right to use said patents, trade marks, etc. herein granted.
On November 23, 1938, a modification was made to paragraph 2 of this agreement allowing the U.S. Tool Co. to permit the General Electric Co. the use of certain of the patents. On October 10, 1939, the petitioner entered into a new and more comprehensive general licensing agreement with the U.S. Tool Co. This agreement contained, inter alia, the following provisions:
WHEREAS, said Licensee has been and is now manufacturing and selling various articles manufactured under the terms of a license agreement involving various patents, inventions, etc., trademarks, etc., dated October 15, 1934, granted by Licensor, which said license agreement expires October 15, 1939; and
WHEREAS, in order to encourage the building up of a market for products manufactured under the patents, etc. as set forth in the said agreement, and others subsequently included under the same terms by oral agreement, said Licensor did not, under the terms of the existing license, require the payment of any royalties on the said license other than the payment of development expenses, as set forth in the said agreement, but it is now apparent to both Licensor and Licensee that there are prospects of substantial business from the sale of articles produced under the patents, etc. covered by the said license, and Licensee has agreed that a royalty of five per cent (5 percent) on the gross sales of products manufactured under such license is fair in addition to the continued payment of any development expenses on patents, inventions, etc. covered by the present license or which may hereafter be included in a future license; and
WHEREAS, Licensor is willing to grant a new license covering all the patents, inventions, trademarks, etc. included in the present agreement, as well as any that may be subsequently added by mutual agreement, either in writing or orally, on the terms hereinafter set forth;
NOW, THEREFORE, in consideration of the sum of One Dollar ($1.00) paid to each other, receipt of which is hereby acknowledged, and of the mutual covenants and agreements hereinafter set forth, said parties have agreed as follows:
1. LICENSE AND RENEWAL PROVISION.
Licensor hereby gives and grants unto the Licensee, subject to the conditions hereinafter set forth, the exclusive right and license to manufacture, have manufactured for it, and sell, and sell to others for use or sale throughout the United States, its territories and colonial possessions, the various products referred to above under the patents or applications or inventions, etc. as listed in the Schedule annexed to this agreement and under any patent or patents that may hereafter issue for inventions set forth in any applications now pending or which may hereafter be pending, or any reissue thereof, and under any patent or patents for such articles that may hereafter be acquired, obtained or controlled by the Licensor in anywise related to the aforesaid patents, provided that any such after-acquired patents, inventions, or trademarks not specifically set forth in this agreement may be covered by the terms of this agreement if mutually agreed to by the parties hereto, either in writing or orally. Such license shall extend from October 15, 1939 to October 15, 1941 unless earlier terminated as hereinafter provided. It is mutually agreed that unless notice is given by either party to the other, as hereinafter provided, on or before April 15, 1941 that such party does not desire to renew the agreement, then this agreement shall automatically be renewed for a period of one year from October 15, 1941, and thereafter shall automatically renew itself each year unless and until such six months' prior notice is served by either party in any year that such party does not desire to renew the agreement. Any such notice shall be sent by registered mail to the above addresses unless a new address shall have been furnished prior to the sending of such notice. This provision for automatic renewal is subject to the other provisions hereinafter referred to in this agreement relating to cancellation or termination. All of the rights covered by this license are hereinafter collectively referred to as ‘license rights.‘
2. ROYALTIES.
Said Licensee agrees that during the continuance of this agreement it will pay to the said Licensor, its successors or assigns, royalties on the devices or products manufactured and/or sold by Licensee, or anyone deriving rights through Licensee, which royalty shall be at the rate of five per cent (5 percent) of the gross sales of products manufactured by any of such parties under the said license rights; the said payments or royalties shall become due and be paid on the 15th of each month for shipments made or paid for up to and including the last day of the preceding month, to which royalty dates the accounts hereinafter provided for are to be made up. The period in which the said royalties shall be computed shall begin on October 15, 1939. The gross sales price hereinabove referred to shall not be interpreted to include customary discounts allowed by Licensee on sales of articles covered by this agreement. In addition to the above mentioned percentage on the gross sales, Licensee agrees that as part of the consideration for the said license, it will, during the continuance of this agreement, continue to make complete payment of all expenses in connection with the obtaining and developing of any patents, inventions, trademarks, etc. covered by this agreement, as set forth in the annexed Schedule, or which shall hereafter be brought within the terms of this license by mutual agreement of the parties, either orally or in writing.
On September 1, 1939, a special meeting of the board of directors of petitioner adopted the following resolution:
A special meeting of the Board of Directors of the Associated Patentees, Inc. was held at the Office of the Company, 19th Street and Springdale Avenue, Ampere (East Orange) New Jersey, on Friday, September 1, 1939 at 2 P.M., proper notice having been sent to the Directors in accordance with the By-Laws.
The following directors were present: C. Todd, Alwyn E. Borton, F. Koch and W. P. Powers.
The meeting was called to order by the President, Mr. Borton. On motion duly made and seconded it was unanimously
RESOLVED, that the Secretary be, and hereby is authorized and directed to rent a safe deposit box from the Ampere Bank and Trust Company, East Orange, N.J. it being understood that access to said box shall be granted to any two of the present Directors of the Company who are C. Todd, Alwyn E. Borton, F. Koch and W. P. Powers. On motion duly made and seconded it was unanimously
RESOLVED, that the President and Secretary of this Company be and hereby are authorized to negotiate and enter into a new license agreement with the U.S. Tool Company, Inc., to succeed the present agreement which expires on October 15, 1939, providing for the licensing of the manufacture and sale of products covered by patents, inventions, trademarks, etc. owned or controlled by this Company on terms of 5 percent royalty on gross sales plus development expenses as at present, the other terms to be as approved by said officers, it being the understanding of this Company with its four stockholders, C. Todd, Alwyn E. Borton, F. Koch and W. P. Powers, that as partial compensation for patents, inventions, ideas, etc. turned over to this Company by them since the incorporation of this Company, one-fifth of any cash royalties actually received by this Company is to be paid over to each of said individuals, and that each of said individuals, while acting as an officer of this Company, is to receive a salary of $1,500.00 per year as compensation for such services, if the cash income received by this Company during any such year is sufficient to pay such salaries after the payment of 80 percent of said royalties, and that in case such income is insufficient to pay such salaries in full, any reduction shall be pro-rated among the four officers.
On motion duly made and seconded the meeting adjourned.
(Signed) W. P. POWERS Secretary
At a special meeting of the directors of the petitioner held on December 16, 1940, the following resolutions were adopted:
On motion duly made and seconded, it was unanimously RESOLVED:
1. That the salaries of the officers for the year 1940 in the amount of $1500.00 each be paid before the close of business December 31, 1940.
On motion made and seconded, it was unanimously RESOLVED:
2. That the Treasurer be, and hereby is instructed to distribute on or before December 31, 1940 as dividends all available income after paying salaries and other obligations.
Mr. Todd brought up the fact that in reviewing the Minutes of previous Meetings, that the Minutes of the Special Meeting of the Board of Directors of September 1, 1939 did not clearly express the arrangement between the four Officers of the Company and the Company regarding patents turned over to the Company by them. The arrangement was that the payment to them of 80 percent of the Annual Royalties received from the patents, inventions, etc. that were turned over to us by them was to pay them for the use of such patents, etc. during the year in which such royalties are received, and for keeping such patents, etc. active and up to date, and such 80 percent was not paid to them in whole or in part as purchase money for such patents and inventions, etc. It was also understood that the 80 percent of royalties received on such patents was to continue for the life of the patents, and any extensions thereof. Mr. Todd said that at the time he noticed this ambiguity he made notations on the Minutes accordingly, and now wishes to have this properly stated in these Minutes.
On motion duly made and seconded, it was therefore RESOLVED: That thse statements be included in these Minutes.
The following instrument was executed by the petitioner and the four individuals:
WHEREAS, since January 14, 1933, C. Todd, A. E. Borton, F. Koch and W. P. Powers have made certain inventions and have obtained numerous patents, and
WHEREAS, the said C. Todd, A. E. Borton, F. Koch and W. P. Powers are now working on numerous inventions and are applying for and seeking numerous patents, and
WHEREAS, the patents as obtained have been turned over to Associated Patentees, Inc., from time to time without any arrangement being made as to compensation, and
WHEREAS, the understanding was that the parties would arrive at the matter of compensation in due time, and
WHEREAS, Associated Patentees, Inc., have licensed certain patents and invention to others, and are obtaining certain royalties from time to time, and
WHEREAS, almost the entire income of Associated Patentees, Inc., consists of royalties received from licensing others to use these patents and inventions, and
WHEREAS, a verbal arrangement was made earlier this year to the effect that the Associated Patentees, Inc., would pay to each C. Todd, A. E. Borton, F. Koch, and W. P. Powers, 20 percent of all royalties receive for the use of the patents and inventions turned over by them since January 14, 1933, to Associated Patentees, Inc., and
WHEREAS, it is thought wise, because of the volume of business being done, and for other reasons, to reduce the whole arrangment to writing.
NOW THIS CONTRACT WITNESSETH:
THAT in consideration of one dollar, and other good and valuable considerations, the receipt whereof is hereby acknowledged, and in consideration of the use of numerous patents and inventions as listed on attached Schedule A, and in further consideration of the promise on the part of C. Todd, A. E. Borton, F. Koch, and W. P. Powers to keep such patents and inventions current in so far as they can do so, and in further consideration of the promise on the part of C. Todd, A. E. Borton, F. Koch, and W. P. Powers to turn over any inventions they may make to the Associated Patentees, Inc., the Associated Patentees, Inc., this 31st day of December, 1940, agrees to pay to each of the said C. Todd, A. E. Borton, F. Koch, and W. P. Powers, as royalties for the use of the patents and inventions turned over to Associated Patentees, Inc. since January 14, 1933, as shown in Exhibit A attached, an amount of cash equal to twenty (20) per cent of all royalties received by the said Associated Patentees, Inc.; and
Further, the Associated Patentees, Inc. agrees to pay to each of the said C. Todd, A. E. Borton, F. Koch and W. P. Powers as royalties for the use of the patents and inventions turned over to the Associated Patentees, Inc., since January 14, 1933, as shown on Exhibit A attached, and as royalties for the use of patents and inventions to be turned over by the said C. Todd, A. E. Borton, F. Koch, and W. P. Powers, to the Associated Patentees, Inc. in the future, an amount of cash equal to twenty (20) per cent of all royalties that Associated Patentees, Inc., hereafter receives.
This contract shall continue in full force and effect during the entire life of said patents and inventions, including the life of any patents and inventions that may be turned over to the Associated Patentees, Inc., in the future.
ASSOCIATED PATENTEES, INC. By (Signed) A. E. BORTON President C. TODD A. E. BORTON FREDERICK KOCH W. P. POWERS
(Signed) W. P. POWERS
Secretary
Prior to the end of 1940 petitioner paid $42,209.76 to the four individuals in equal amounts.
The value of the patents in question was far in excess of $42,209.76, the amount of the payments made by petitioner to the individuals for the calendar year 1940. These payments were capital expenditures in acquisition of legal and equitable title to the patents.
OPINION.
LEECH, Judge:
Petitioner asks us to find from the evidence introduced upon the rehearing that the patents in question had a cost to it of $3,000,000. This we can not do. That evidence was directed to the question of value, whereas the question we have is one of cost. Moreover, that evidence consists of an opinion based upon such uncertain factors that we do not think it carries weight in determining the value of the patents. We are convinced, however, from the testimony that the patents had great value, largely in excess of the total amounts paid by petitioner in the year 1940, and have so found.
Petitioner acquired the patents from four individuals. The patents had varying lives. The consideration to be paid for the patents was 80 percent of the yearly income received by petitioner from licenses granted by it to use the patents. The four individuals further contracted, in consideration of petitioner's agreement to make these annual payments, to perform services in keeping up the patents, all improvements thereon invented by them to become the property of the petitioner.
Thus the amount of $42,209.76, paid in 1940 by petitioner under the contract, in no sense constitutes the total cost of the patents. This cost includes the future payments which will be made and can not be determined until the expiration of the patents, at which time their value passes out. Of course, it is unquestioned that petitioner is 'entitled to recover this total cost through reasonable deductions for exhaustion over the period of their lives. The obstacle to computation of depreciation over the term of the lives of the patents in the ordinary way by a proration of total cost is the fact that we have here the first year of the term. It is impossible to determine in this year what the total cost will be, since it will include a percentage of earnings of petitioner in each year of that term. These earnings can not now be determined.
Under these conditions, it is respondent's contention that for the year 1940 there should be allowed as depreciation only a proportionate part of the $42,209.76 paid in that year, the balance of that cost to be prorated over the succeeding years of the lives of the patents, and that in each succeeding year there should be allowed depreciation upon payments made therein based upon the then remaining lives of the patents, petitioner to be allowed this amount plus the amount of depreciation allocated to such succeeding year from prior payments.
It will readily be seen that although this method of computation will give to the petitioner aggregate theoretical deductions for depreciation equaling the total ultimate cost, its practical result will be an entirely inadequate allowance for depreciation at the beginning of the term and excessive allowances for depreciation at the end. Actually, in the later years, the depreciation allowances would largely exceed income from the patents. Under such a method of computation the petitioner might not, in fact, recover its cost from income.
Petitioner's contention is that the cost payment made each year is subject to depreciation in its full amount because it is a cost pertaining to that year alone and measured by income over that period. It is argued that, with an allowance so made, at the close of the lives of the patents the petitioner will have recovered the amount of their cost prorated equitably over their lives.
Section 23(1) provides for ‘a reasonable allowance‘ for depreciation. It provides no specific method for its computation. Respondent's regulations
recognize the fact that there is no fixed rule, but that the cost should be apportioned over the useful life in such ratable amount as may reasonably be considered necessary to recover during the remaining useful life of the property the unrecovered cost or other basis. The situation here is unusual. But we think that the method for computing depreciation for which petitioner argues gives it a reasonable, and not more than a reasonable, allowance, whereas the method urged by respondent might deny petitioner the recovery of its cost and would unquestionably result in a distortion of income.
Regulations 111—‘SEC. 29.23(i)-5. Method of Computing Depreciation Allowance.— The capital sum to be recovered shall be charged off over the useful life of the property, either in equal annual installments or in accordance with any other recognized trade practice, such as an apportionment of the capital sum over units of production. Whatever plan or method of apportionment is adopted must be reasonable and must have due regard to operating conditions during the taxable period. The reasonableness of any claim for depreciation shall be determined upon the conditions known to exist at the end of the period for which the return is made. * * * ‘
The situation here is substantially identical with that in John A. Nelson Co., 28 B.T.A. 529, in which case we allowed deduction of the yearly payment.
JC987 The Nelson case, supra, was reviewed by the Circuit Court and our decision was affirmed (75 Fed.(2d) 696). On certiorari to the Supreme Court the opinion of the Circuit Court was reversed (296 U.S. 374). In the review by the Circuit Court and the Supreme Court, the issue in that case of the propriety of the deduction allowed by our opinion was not involved.
Accordingly, we have found here, as we did in our earlier opinion, that petitioner acquired legal and equitable title to the patents in question prior to the tax year. But we now hold that in computing its contested taxes for that year petitioner is entitled to a deduction for exhaustion of the patents equal to the total payments of $42,209.76 made in that year.
Decision will be entered for the petitioner.