*2333 1. The cost of a patent to petitioner in 1923 determined and a deduction for exhaustion thereof based upon such cost allowed for the year 1923.
2. Held that under the Revenue Acts of 1924 and 1926 the basis for the computation of exhaustion on the patent for the years 1924, 1925, and 1926 is the basis in the hands of the transferor of the patent. In the absence of such basis, the determination of the respondent is upheld.
*206 These are proceedings duly consolidated for hearing and decision for the redetermination of deficiencies in income and excess-profits taxes as follows:
| Docket No. | Year | Deficiency |
| 1923 | $3,280.38 | |
| 21943 | 1924 | 5,380.37 |
| 1925 | 9,504.46 | |
| 36268 | 1926 | 13,624.31 |
The petitioner in Docket No. 21943 alleges that the respondent erred in reducing the value of patents acquired by the petitioner on or about July 8, 1923, from the $250,000 claimed by the petitioner to $70,672.12, and that as a result of this there was an erroneous disallowance of depreciation in the year*2334 1923.
In Docket No. 36268 it is alleged that the respondent erred in disallowing depreciation on the patents in question for the years 1924, 1925, and 1926. It is also alleged that the respondent erred in contending that no records were available from which to determine the cost of the patents or their March 1, 1913, value.
FINDINGS OF FACT.
The petitioner is an Illinois corporation, with its principal office at Chicago. It engages in the manufacture and sale of the James Patent Speed Reducing Transmission, which operates on the planetary gear system. This machine can furnish any reduction of speed from the ratio of 4 to 1 to 1,600 to 1.
The planetary system produced a greater reduction from high speed to low with less gears than any kind of gear-reduction machines. The planetary system of speed-reducing transmission was invented by a man in England about 1862. Some years thereafter one Kelly patented a speed-reducing transmission in the United States and D. O. James, trusting to the validity of Kelly's patent, paid royalties to Kelly in an amount in excess of $4,000 on these machines which James manufactured. Later an infringement suit was instituted between Kelly*2335 and one Foote, which resulted in a judgment disclosing that the machines being manufactured by James were not covered by the patent held by Kelly and James thereafter declined to pay further royalties to Kelly and was sued by Kelly's son. James was successful in the litigation and has continued ever since to manufacture *207 the planetary speed-reduction transmission. These events transpired several years before the incorporation of petitioner in 1908. Petitioner succeeded to the business which had been conducted by D. O. James as an individual.
From the beginning of the manufacture of these speed-reduction transmissions it was impossible to keep them well lubricated, because the oil was forced out of the machine. There was no device to stop this outflow of oil and it could not be held in by any kind of stuffing or packing boxes. This defect caused trouble with every machine which the petitioner made. The machines could not be used with this defect and unless it could be remedied sales of the machines would be stopped completely and the company's business would be at an end so far as the sale of these machines was concerned. There was also a fire hazard due to the*2336 spilling of oil from these machines.
About the year 1908 or 1909 D. O. James found a solution of the difficulty. He invented a device which would prevent the loss of oil. This device, known as "The James Patent Oil Deflector," was patented by D. O. James on November 30, 1909, and became patent No. 941,925. This patent was immediately put into use in the manufacture of machines by the petitioner and has been so used ever since. This deflector is absolutely essential to the planetary system of gearing in speed-reduction machines. The petitioner is the only company which makes this planetary type of transmission reduction and the petitioner can furnish wider and larger faced gears than any of its competitors. This is due principally to the use of the James Patent Oil Deflector.
The adoption of the James Patent Oil Deflector had a decided effect on the company's business. The company could then assure the customer that oil leakage had been eliminated. Since petitioner began using this device in its machines it has greatly increased and expanded its business plant. Its plant formerly was a two-story building covering a lot 40 by 100 feet. Afterwards its plant consisted of*2337 one two-story building occupying a lot 120 by 120 feet. The sales of the petitioner were as follows:
| Year | Amount | Number of machines |
| 1910 | $60,355.97 | |
| 1911 | 45,906.71 | |
| 1912 | 25,258.66 | |
| 1913 | (1) | |
| 1914 | 82,938.83 | |
| 1915 | 97,418.76 | |
| 1916 | 145,174.75 | |
| 1917 | 289,344.21 | |
| 1918 | 457,718.70 | 1,022 |
| 1919 | $357,260.92 | 758 |
| 1920 | 558,946.16 | 886 |
| 1921 | 206,914.04 | 368 |
| 1922 | 265,055.98 | 960 |
| 1923 | 533,197.48 | 1,636 |
| 1924 | 543,714.75 | 1,766 |
| 1925 | 756,934.60 | 2,378 |
| 1926 | 977,195.43 | 2,910 |
*208 In the years 1921 and 1922 there was a period of general business depression, which affected the sales of petitioner in those years.
The greater portion of the sales indicated represents sales of speed-reduction transmission machines. The sales also included parts of such machines which depended for their sales on the sales of the machines and were consequently dependent upon the James Patent Oil Deflector. The petitioner also produced and sold some other products which were not related to these machines, but the amount of this business was minor. The expansion of the petitioner's business was due to the James Patent Oil Deflector.
The petitioner*2338 has been able to retain its customers from the date of incorporation to the present. Among such consistent customers of the petitioner are the Ford Co., the General Electric Co., Armour & Co., B. F. Goodrich & Co., General Felt Co., the American Flour Co., the American Maize Products Co., the Universal Portland Cement Co., Eastman Kodak Co., Milwaukee Electric Ry. Co., F. L. Smith Co., the Crown Cork & Seal Co., Thomas Elevator Co., the Quaker Oats Co., and others.
By July 1, 1923, the petitioner had accumulated a surplus of $273,431.17, which was its surplus on that date. On July 2, 1923, D. O. James submitted to the petitioner in writing an offer of sale of the patent on the James Patent Oil Deflector for a consideration of $250,000 in cash or in stock of the company.
The minutes of the meeting of the board of directors of the D. O. James Manufacturing Co. held July 5, 1923, were as follows:
The meeting was called to order by D. O. James, President, who stated the object of the meeting to be the consideration of the acquisition of the D. O. James patent of November 30th, 1909, also any other business that might come before this meeting.
The first order of business was*2339 the reading and approval of the minutes of the previous meeting. Upon motion the minutes were approved as read.
The President stated that D. O. James, the owner of the James Patent had offered the patent to this Corporation for two hundred fifty thousand dollars ($250,000) and that said sum could either be paid in cash or in twenty-five hundred shares of the capital stock of the D. O. James Manufacturing Company. Discussion ensued and on motion, the President and Vice-President were authorized to execute an agreement between the Corporation and the owner of the patent, D. O. James, for the acquisition of this patent either in cash or in stock of this Corporation.
The President presented to the attention of the Board the written proposal of D. O. James to transfer and assign to this corporation, the aforementioned patent, which was read by the Secretary, and which said proposal is in these words:
D. O. JAMES MANUFACTURING CO.,1120 West Monroe Street, Chicago, Illinois.
GENTLEMEN:
I hereby offer to the D. O. James Manufacturing Company, any and all right, title and interest that I may now have, or ever had in the *209 James Patent Oil Deflector, procured November*2340 30th, 1909, and offer this to you for the sum of two hundred fifty thousand dollars ($250,000) in cash, or in stock of your corporation, provided you accept this proposition within ten days hereafter.
Dated at Chicago, Illinois, this second day of July, 1923.
Yours truly,
(Signed) D. O. JAMES.
After due consideration of said proposal, the following resolution was adopted:
Whereas, D. O. James owner of the James Patent of November 30th, 1909, has offered to this Corporation all his right, title and interest in and to said patent, together with all property rights and good will of said patent,
Whereas, in the opinion of this Board, after due consideration regarding the value of said Patent,
Whereas, this corporation can use said Patent to advantage;
Therefore, be it resolved that this Board purchase the said patent and good will of said patent for the sum of two hundred fifty thousand dollars ($250,000) in cash, or in stock of this Corporation.
Be it further resolved that the President, and Vice President of this Corporation are hereby instructed to take the proper legal steps to secure the transfer and assignment of said patent and any and all future rights, title*2341 and interest of the said D. O. James in and to the said patent to the extent of the aforementioned amount.
The transaction was closed shortly after July 2, 1923.
On January 1, 1923, the petitioner had outstanding capital stock in the amount of $30,000, composed of 300 shares of a par value of $100 per share. D. O. James owned 156 of these shares. During 1923 the authorized capital stock of the petitioner was increased from 300 shares to 3,000 shares having a par value of $100 per share. As a result of the transaction by which the patent was conveyed to the petitioner, 2,500 shares of the additional capital stock were issued to D. O. James. The remaining 200 shares of the additional stock remained in the treasury of the petitioner as treasury stock. The 2,500 shares of stock issued to D. O. James were worth $250,000 at the time issued to him.
The expiration date of the patent was November 30, 1926. At the date of the transfer of the patent from D. O. James to the petitioner, the patent had an unexpired life of three years and five months.
For the year 1923 the petitioner deducted 6/41 of $250,000 (36,585.30) from its gross income on account of exhaustion of the said*2342 patent. The Commissioner reduced the basis for exhaustion to $70,672.12 and allowed 6/41 thereof ($10,342.26) and disallowed $26,243.04 of the exhaustion deduction claimed by petitioner.
For the years 1924, 1925, and 1926, the petitioner deducted, from gross income on account of exhaustion of the said patent, 12/41 ($73,170.72), 12/41 ($73,170.72), and 11/41 ($67,073.26), respectively, *210 of $250,000. The Commissioner disallowed all claims for exhaustion in those years.
OPINION.
SIEFKIN: The sole question for determination in this proceeding is the basis for calculation of exhaustion of a patent during the years 1923, 1924, 1925, and 1926. The patent in question is known as "The James Patent Oil Deflector," which was transferred to the petitioner by D. O. James shortly after July 2, 1923, in exchange for $250,000 par value of stock of the petitioner. This stock at the time of the transaction had a value of $250,000. For the year 1923 the respondent used a basis of $70,672.12 instead of the $250,000 claimed by the petitioner and for the years 1924, 1925, and 1926 he allowed no deduction for exhaustion of the patent.
Section 234(a) of the Revenue Act of 1921*2343 provides: for exhaustion of the patent.
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 basis for the computation of depreciation in the case of property acquired subsequent to March 1, 1913, is its cost. Section 331 of the Revenue Act of 1921 has no application here. See . For the year 1923 petitioner is entitled to depreciation upon the cost of the patent, $250,000.
We now turn to a consideration of the basis for computation of depreciation for the years 1924, 1925, and 1926. There are set forth below pertinent sections of the Revenue Act of 1924 which are similar to provisions of the Revenue Act of 1926.
Section 204(c) provides:
(c) The basis upon which depletion, exhaustion wear and tear and obsolescence are to be allowed in respect of any property shall be the same as is provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the*2344 sale or other disposition of such property.
Section 204(a) provides:
(a) The basis for determining the gain or loss from the sale or other disposition of property acquired after February 28, 1913, shall be the cost of such property; except that -
* * *
(8) If the property (other than stock or securities in a corporation a party to a reorganization) was acquired after December 31, 1920, by a corporation by the issuance of its stock or securities in connection with a transaction described in paragraph (4) of subdivision (b) of section 203 (including, also, cases where part of the consideration for the transfer of such property to the corporation was property or money in addition to such stock or securities), *211 then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made; * * *
Section 203(b)(4) provides:
No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, *2345 and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange.
Section 204(c) of the Revenue Act of 1924 provides that the basis upon which depreciation is to be allowed shall be the same as is provided in subdivision (a) or (b) for the purpose of determining gain or loss upon the sale or other disposition of such property.
Section 204(a) of the Revenue Act of 1924 provides that the basis for determining gain or loss on the sale or other disposition of property acquired after February 28, 1913, shall be the cost of such property, with certain exceptions. One of the exceptions is set forth in subdivision (8).
Subdivision (8) provides that if the property was acquired after December 31, 1920, by a corporation by the issuance of its stock or securities in connection with a transaction described in paragraph (4) of subidivision (b) of section 203, then the basis shall be the same as it would be in the hands of the transferor, *2346 increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made.
The type of transaction referred to in section 203(b)(4) of the Revenue Act of 1924 is that in which property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation.
It seems clear that the transaction in this case falls within section 203(b)(4), and the basis for calculating depreciation on the property exchanged is the basis in the hands of James, increased in the amount of any gain derived, or decreased by the amount of loss sustained upon the transaction as recognized by the law applicable to the year 1923, the year the transaction was made. The law applicable is the Revenue Act of 1921.
*212 Section 202(c) of the Revenue Act of 1921 provides:
For the purposes of this title, on an exchange of property, real, personal or mixed, for any other such property, no gain or loss shall be recognized unless the property received in exchange*2347 has a readily realizable market value; but even if the property received in exchange has a readily realizable market value, no gain or loss shall be recognized -
* * *
(3) When (A) a person transfers any property, real, personal or mixed, to a corporation, and immediately after the transfer is in control of such corporation, or (B) two or more persons transfer any such property to a corporation, and immediately after the transfer are in control of such corporation, and the amounts of stock, securities, or both, received by such persons are in substantially the same proportion as their interests in the property before such transfer. For the purposes of this paragraph, a person is, or two or more persons are, "in control" of a corporation when owning at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of the corporation.
Since James owned over 80 per cent of the stock of the corporation after the transaction no gain or loss would be recognized. The basis for depreciation, therefore, is the basis in his hands. What is that basis?
Section 202(b) of the Revenue Act of 1921 provides that the basis*2348 for ascertaining gain or loss upon the sale or other disposition of property acquired before March 1, 1913, shall be the cost or March 1, 1913, value, whichever is higher.
We are without evidence as to the cost of the patent to James and the evidence as to its March 1, 1913, value in his hands is not sufficient to enable us to make a finding of fact as to such value which would be more than a conjecture. Under such circumstance the determination of the respondent as to the years 1924, 1925, and 1926 must be upheld.
The petitioner depends upon , but that case is not in point. It did not involve section 202(c)(3) of the Revenue Act of 1921, the section involved in this proceeding.
Reviewed by the Board.
Judgment will be entered under Rule 50.
Footnotes
1. Not available. ↩