*676 1. Petitioner canceled royalties and other debts accrued prior to the taxable year and also royalties accrued for the first six months of the taxable in consideration of a release from certain restrictive covenants in a contract. Held, such cancellation is a capital expenditure; held, further, the royalties accrued for the first six months of the taxable year are properly includable in gross income.
2. Penalties for failure to file returns on time are not to be assessed where petitioner has shown reasonable cause. Sec. 291, Revenue Act of 1936.
*565 The Commissioner has determined deficiencies and penalties for the calendar year 1937 as follows:
| Deficiency | Penalty | |
| Income tax | $3,156.14 | $266.27 |
| Personal holding company surtax | 9,703.05 | 970.31 |
The primary issue is whether petitioner is entitled to a deduction, as an ordinary and necessary business expense or as an ordinary loss, in the amount of $11,064.68 or any part of that sum, which petitioner had canceled as the result of certain*677 negotiations set forth below. There is an alternative issue - whether or not the royalties for the *566 first six months which had accrued and were canceled should be included in gross income. An additional issue involves the question of delinquency penalties for failure to file returns within the statutory time.
FINDINGS OF FACT.
Petitioner is a corporation organized in 1934 under the laws of Delaware. It acquired its assets from an Ohio corporation of the same name. Petitioner filed its tentative income tax return for the calendar year 1937 on March 21, 1938. It filed an amended income tax return on April 20, 1938, and on that day also filed its personal holding company return. All returns were filed with the collector of internal revenue for the district of Maryland.
The assets of petitioner consisted of patents and patent applications covering the croquignole hair curling process and licenses which had been granted to certain manufacturers of permanent wave machines and equipment used in the croquignole process. Petitioner's sole business is the granting of such licenses and the collection of royalties from the licensees.
Substantially all the licenses*678 in effect during 1936 and 1937 contained the following clause:
:10) It is understood and agreed that the total number of licenses granted under the Licensor's patents covered by this agreement shall not, except as hereinafter provided, exceed ten :10) licenses, inclusive of this present license. The Licensor agrees that if hereafter a license is granted to any other person or corporation under any of the patent rights herein licensed on terms as to royalty, price schedule or other terms or provisions which are more favorable to such other licensees than those herein granted to Licensee, it shall forthwith grant to Licensee such more favorable terms and provisions and this license agreement shall forthwith be deemed modified accordingly.
* * *
Prior to July 1937 petitioner had issued approximately ten licenses. The largest manufacturer holding a license was the Realistic Permanent Wave Machine Co., hereinafter referred to as Realistic.
Sometime prior to July 1937 the officers and directors of petitioner determined that it would be to its interest to obtain waivers and releases from the restrictive provision relating to the number of licenses which petitioner might have outstanding*679 and also the clause. Since Realistic was one of the largest of the licensees, petitioner attempted to get Realistic to waive this provision in its license. Petitioner's officers believed that if Realistic would waive such provision petitioner would be in a better position to approach the other licensees. The negotiations had been started with Realistic in the early part of 1937. As a consideration for such waiver Realistic demanded that it be released from all liabilities to petitioner and that it thereafter be required to pay no royalties for the use of the patents.
*567 During the time that petitioner was negotiating with Realistic it also carried on negotiations with the other holders of the outstanding licenses in an effort to obtain similar waivers. Ultimately, substantially all of the licensees, other than Realistic, consented to the waivers in consideration of the reduction of their royalty rates from 6 percent to 4 1/2 percent. Only one company did not consent. During negotiations with the nonconsenting company petitioner felt that it was no longer material, since that company had breached its contract and petitioner could cancel its license. As a result of*680 the waivers petitioner thereafter granted licenses to additional manufacturers of permanent wave equipment so that at various times subsequent to July 1937 petitioner had more than ten licenses outstanding.
A. Kietz and Phil D. Spaeth were the principal and controlling stockholders of both the petitioner and Realistic. Kietz was president and Spaeth was vice president of petitioner, and Spaeth was president and Kietz was vice president of Realistic.
Realistic had an exclusive distributor of its products for the whole United States and during but prior to July 17, 1937, the distributor owed large sums of money to Realistic and was unable to continue as such distributor, whereby the sales and distribution of Realistic's products upon which royalties were payable to petitioner were greatly curtailed. Kietz was financially involved in the affairs of Realistic's distributor and this fact caused or accentuated strained relations between Kietz and Spaeth. The two men were in an unhappy mood toward each other and as a result they determined upon a separation of their interests in the two corporations. At the same time petitioner was seeking a release from the provision in each of*681 its licensee's agreements restricting petitioner from having outstanding at any one time more than ten licensees of its patents.
A meeting between the stockholders, directors, and officers of petitioner and of Realistic was held at Cincinnati, Ohio, on July 17, 1937, at which an agreement was reached embracing :1) the release by Realistic of the provision of its license agreement restricting to 10 the number of outstanding licenses which petitioner could grant; :2) the cancellation by petitioner of all unpaid and future royalties from Realistic as licensee of petitioner plus all other accounts due from Realistic to petitioner; and :3) the separation of the interests of Kietz and Spaeth in the two corporations through an exchange of the stock which Kietz had in Realistic for the stock which Spaeth had in petitioner. This agreement was formally ratified by petitioner on November 22, 1937, by resolution of its board of directors as follows:
THEREUPON the financial affairs of this Corporation, The Realistic Permanent Wave Machine Company, were discussed.
*568 Upon due discussion, the following resolution was presented on motion duly made and seconded, the same was adopted:
*682 RESOLVED, THAT WHEREAS the President of this Company advised this Board of the separation of interest of the respective officers, Directors and Stockholders of the Realistic Permanent Wave Machine Company, and of the Philad Company, which took place in July, 1937,
AND WHEREAS the President advised the Board that the claim by the Philad Company as against The Realistic is due to circumstances in his opinion, uncollectible, and advised the canceling and writing off of this amount on the books of the Company,
AND WHEREAS, in the settlement of the aforesaid separation of interest, the President, in behalf of this Company, assigned certain other claims,
NOW, THEREFORE,
BE IT RESOLVED THAT the assignment by the President of the Philad Company to Phil D. Spaeth, President or The Realistic, of any and all claims for royalties from The Realistic Permanent Wave Machine Company which may now or hereafter be due and payable to the Philad Company, be and hereby is approved and ratified.
BE IT FURTHER RESOLVED THAT the indebtedness of The Realistic to this Corporation in the amount of $549.31 be and hereby is canceled.
BE IT FURTHER RESOLVED THAT the Auditor of this Company be and*683 is hereby instructed to cancel said indebtedness and write it off the books of this Company, and to take cognizance, likewise, of the relinquishment of any claim for royalties which have been or may be due, now or hereafter to this Company by The Realistic Permanent Wave Machine Company.
The above mentioned assignment to Spaeth was understood and intended to be, and was in fact, a cancellation of past and future royalties from Realistic to petitioner. The only purpose of such assignment rather than an outright cancellation to Realistic was to preclude, pending the securing of releases from other licensees, assertion of claims under the so-called the license agreements.
The debts which petitioner canceled as a result of the negotiations with Realistic were as follows:
| Charges for 1936 royalties which had been accrued but unpaid | $3,469.77 |
| Charges for 1937 royalties prior to July 1937 | 7,045.60 |
| Miscellaneous intercompany accounts receivable | 549.31 |
| Total | 11,064.68 |
The petitioner filed its income tax and personal holding company returns within four days after the Commissioner, in a litter dated March 17, 1938, had refused to grant an extension asked for by*684 the petitioner. The request for an extension of time was made because petitioner reported its income on the accrual basis and it was unable to determine the correct amount of income to be accrued before March 15, 1938. Petitioner's failure to file its returns on time was due to a reasonable cause.
*569 OPINION.
HILL: The first issue of this proceeding is whether or not petitioner is entitled to a deduction, as a necessary and ordinary business expense or as an ordinary loss, in the amount of accounts canceled in a settlement made with Realistic. A second issue :alternative to the first) is whether petitioner must include the royalties which became due and payable during the first six months of the taxable year in gross income. A third issue is whether delinquency penalties should be imposed for failure to file returns within the time prescribed by statute.
Petitioner contends the action of the respondent in not allowing the deduction as an ordinary and necessary business expense or as an ordinary loss is erroneous. It also claims that, even if this action were not in error, respondent ought not to have included in gross income the amount of royalties due from Realistic*685 for the first six months of the taxable year. In support of its argument on the first contention petitioner cites and relies chiefly upon Helvering v.Community Bond & Mortgage Co., 74 Fed.:2d) 727, and . Petitioner also cites sever cases which allow compromise settlements to be deducted as ordinary and necessary business expenses. As authority for its position that the royalties accrued for the first six months of the taxable year should not be included in gross income petitioner cites ; ; .
Petitioner's position that the royalties for the first six months of the taxable year should not be included in gross income is premised upon the cases set forth above, in which it was held that a readjustment of an item prior to the end of a taxable year should be given effect in the computation of gross income for that year. In most of those cases the items which were adjusted were annual items such as salary for the full year which was readjusted*686 prior to the end of the year. In the Huntington-Redondo Co. case, the only adjustment made was a bookkeeping entry. In the instant case there was no readjustment by a change in the rate nor reversal of bookkeeping entries but rather a complete cancellation of the accrued royalties which had become due and payable at all events. These royalties were not computed in regard to any definite period but rather upon the amounts of machinery manufactured. Thus, we hold that the royalties which had accrued to petitioner in the first six months of the taxable year were includable in gross income.
The only question left for our consideration is whether the cancellation of all the debts was a capital expenditure or not. The respondent contends that the cancellation of the various debts owed *570 by Realistic to petitioner was a capital expenditure and therefore is not deductible from gross income either as an expense or a loss.
If we hold that such cancellation was in effect a capital expenditure, petitioner is entitled to no deduction as an ordinary and necessary business expense nor to any deduction as an ordinary loss. The facts show that petitioner had received from*687 its predecessor certain assets which consisted of patents and patent rights. In order to collect income on these patents and rights petitioner or its predecessor had licensed about ten manufacturers under licenses containing a clause limiting to ten the number of licenses outstanding at any one time and containing a these two clauses, which limited petitioner's full use of the patents and effectively stopped petitioner from issuing other licenses. In order to secure the abolition of such restrictions petitioner entered into an agreement with Realistic by which petitioner was released by Realistic from the restrictive covenants in the latter's license agreements. In consideration of that release petitioner canceled the debts owing to it by Realistic and also released Realistic from the payment of royalties in the future under its license agreement. Such release was an important initial step in securing similar releases from petitioner's other licensees, which when accomplished restored to petitioner property rights in respect of its patents which it had previously surrendered in its license agreements. This restored right was a capital asset which petitioner did not have prior*688 to the releases secured first from Realistic and subsequently from its other licensees. The consideration paid to acquire such right was a capital expenditure and such consideration consisted, at least in part, of the cancellation of the debts which it seeks herein to deduct either as ordinary and necessary business expenses or otherwise. We hold that such cancellation constituted a capital expenditure and is not deductible for tax purposes.
Petitioner contends that if such expenditure is held to be a capital expenditure it should be entitled to an amortization deduction in respect thereof. Since we have so held, the amount of the capital expenditure should be added to petitioner's basis for depreciation.
Petitioner's evidence upon the question of penalties is rather meager. However, upon due consideration of all of the evidence we feel warranted in finding as a fact that petitioner's failure was due to reasonable cause. In the recomputation of the deficiency, no penalties shall be included. Sec. 291, Revenue Act of 1936.
Decision will be entered under Rule 50.