General Equipment Co. v. Commissioner

*810OPINION.

Smith:

In its petition the taxpayer alleges that the deficiency determined by the Commissioner is predicated upon the following errors:

(a) That the Commissioner erred in entirely eliminating the account “ Good will and contracts ” in computing the invested capital for profits-tax purposes.

(5) That the Commissioner erred in refusing to permit the taxpayer to take a deduction on account of the exhaustion of certain valuable contracts, constituting the asset referred to in (a) above, in computing the net income for 1919.

*811With respect to the first allegation of error, we find that while the Commissioner has refused to allow, for invested capital purposes, any value for good will and contracts, such action is in no wise responsible for any part of the deficiency on appeal. The invested capital as finally determined by the Commissioner is in such an amount that the credits provided for under sections 311 and 312 of the Eevenue Act of 1918 are greater than the taxable net income determined by the Commissioner, so that no profits taxes result nor does the Commissioner propose to assert any. The deficiency which the Commissioner has found is a deficiency in income tax only, in the computation of which invested capital is not a factor. The first allegation of error, therefore, raises an academic question which we do not deem it necessary to pass upon at this time.

Coming now to the second allegation of error, we are confronted with the question whether the taxpayer is entitled, in the computation of its taxable net income, to a deduction representing a reasonable allowance for exhaustion of the contracts, hereinbefore enumerated and described, under the provisions of section 234(a)(7) of the Eevenue Act of 1918. That section provides as follows:

Sec. 231 (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions: * * *
(7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence.

The theory underlying this provision of the statute is the allowance of a return to the taxpayer of his capital investment before taxing a profit derived in part from the. exhaustion or using up of capital. Appeal of William J. Ostheimer, 1 B. T. A. 18; Appeal of The Brevoort Hotel Co., 1 B. T. A. 132; Appeal of Union Metal Manufacturing Co., 1 B. T. A. 395; Appeal of William Harris, Jr., 2 B. T. A. 156. It is grounded on the fact that most kinds of property approach a point where their usefulness is exhausted either through actual wear and tear, the normal progress of the art, or the effluxion of time. Such an allowance may be made with respect to assets employed in the business, where the lessening in value or their exhaustion is attributable entirely to their gradual diminishing life measured in periods of time, such as copyrights, leaseholds, and patents. And this principle may be extended to contracts and other' intangible property where their life is definitely limited.

The contracts and agreements with respect to which this taxpayer claims an allowance for exhaustion are 31 in number, and they have all been briefly described in our' findings of fact, but for the purpose of applying the principle of law involved we will have occasion to summarize them briefly below.

The most important contract, and the one to which the taxpayer attributes the greatest value, is the agreement dated August 23, 1911, *812by and between the Atlantic Equipment Co. and Samuel G. Allen, H. J. Davis, and Joel S. Coffin, under which the Equipment Company conveyed to those individuals all its business and good will and agreed to refrain from carrying on any similar business for a period of 10 years within a radius of 2,000 miles from the City of New York. This agreement passed by assignments to the first General Equipment Co. and later to this taxpayer. The value of this contract arises, as the taxpayer contends, from the covenant contained therein that the Atlantic Equipment Co. would refrain from doing business for a definite period within a definite territory.

The remaining contracts may be summarized as follows:

(a) Agency contracts for indefinite periods_!_ 10
<5) Agency contracts for five years_ 2
(c) Purchase agreements_ 5
(d) Sales agreements_ 2
(e) Bills of sale_ 11
Total_ 30

With respect to item (a), agency contracts for indefinite periods, it is obvious that no allowance may be made for exhaustion with respect thereto, since no exhaustion is actually taking place, within the purview of the statute, which is susceptible of measurement.

With respect to items (c) and (d), these are mere purchase and sale agreements and apparently were executed and not executory contracts of value in the hands of this taxpayer. All of them are dated from one to four years prior to the date the taxpayer was organized as a corporation, and if they were in existence as executory contracts at the date of organization, and acquired by the taxpayer as such, taxpayer has failed to show by any evidence whatever that such was the case.

Item (e), bills of sale or conveyances of personal property, certainly may not be made the subject of an allowance for exhaustion.

This disposes of all except the Atlantic Equipment Co. agreement dated August 23, 1911, and item (5), agency contracts for five years. At the date these three contracts were acquired by this taxpayer the Atlantic Equipment Co. agreement had a remaining life of but four and one-half years; one of the agency contracts, that of the Western Wheeled Scraper Co., had a remaining life of one and one-third years, and the other agency contract, that of the Central Locomotive & Car Works, had a remaining life of one year and two and one-half months.

What part of the total consideration paid to its predecessor for the total assets and business may be allocated to these three contracts, we do no know. Even if that could be determined it would avail us nothing, since we have no. evidence before us upon which we *813could make a finding as to the value of the capital stock which formed a part of that consideration. Nor has the taxpayer by any competent evidence proven that these particular contracts had a market value at the date acquired by it. How, then, under such circumstances, can we find that it is entitled, in computing its taxable net income, to a deduction for exhaustion of these contracts?

Taxpayer submits a statement showing the average earnings and the average tangible assets employed in the business of its predecessor for the five-year period ending June 30, 1916, and asks us, by providing a fair return on the average tangibles and capitalizing the remaining earnings at a fair rate, to find that the contracts which it acquired from its predecessor had a value of at least $317,250, which was the par value of the capital stock issued for the entire business and assets. But such a method of valuation is clearly fallacious when applied in the valuation of assets of the character of these contracts where time is of the essence. It fails entirely to take into account one of the most important factors, the length of time the contracts have to run. Again, the error of applying such a method is apparent, for it attributes to the contracts all of the earnings over and above a fair return on the tangibles, when as a matter of fact a substantial part of those earnings are attributable to good will. Granting for the sake of argument that such a method might be used, the result obtained by its application would contain three elements: (1) Value of good will, which is not exhaustible; (2) value of the contracts with an indefinite life; and (3) value of contracts with a definite life. We know of no basis upon which the three elements could be segregated.

Of the 31 contracts with respect to which the taxpayer claims an allowance for exhaustion, only 2, or possibly 3, are of such a nature that they may be made the subject of such an allowance. With respect to the latter the taxpayer has failed by any competent evidence to show their value, if they had any, at the date of acquisition.

AeuNdell not participating.