*2330 1. The petitioner was incorporated January 4, 1918, under the laws of the State of Ohio and issued its capital stock to the shareholders of a New Jersey corporation in exchange for their shares of stock in that corporation share for share, after which the petitioner took over the assets of the New Jersey corporation and the New Jersey corporation was dissolved. Held that the invested capital of the petitioner for 1921 was not increased by reason of the exchange. Held, further, that upon the evidence submitted the petitioner is not entitled to include in invested capital any amount in respect of the value of patents paid in to the New Jersey corporation in 1901 for shares of stock.
2. Evidence held insufficient to establish the cost of a patent acquired subsequent to March 1, 1913, and accordingly a claim for a deduction on account of the exhaustion thereof is denied.
*248 This is a proceeding for the redetermination of a deficiency in income and profits tax for the calendar year 1921 in the amount of $11,967.92. The petition as amended*2331 sets forth the following allegations of error.
(1) Respondent has reduced invested capital reported by petitioner in the amount of $124,375, representing patents acquired at organization of the company for stock. This amount of $124,375 represents 25 per cent of the outstanding capital stock as at the beginning of the taxable year 1921, said amount being the limitation of intangibles acquired for stock allowable as invested capital under the provisions of section 326 of the Revenue Act of 1921. Petitioner has used the said amount of $124,375 as a part of its invested capital for the taxable year 1921, whereas, respondent has disallowed that amount, thereby allowing no part of petitioner's patents as a part of its invested capital.
(2) Respondent has failed to allow petitioner any deduction from net income for the taxable year 1921, for depreciation on the March 1, 1913, value of its patents.
At the hearing petitioner waived any claim to exhaustion upon patents except upon Patent No. 945,570, as to which it claims that the March 1, 1913, value was $400,000.
FINDINGS OF FACT.
In September, 1901, there was incorporated under the laws of New Jersey a corporation under*2332 the name of The Miller Pasteurizing Machine Co., with an authorized capital stock of $500,000, consisting *249 of $450,000 par value of common stock and $50,000 preferred stock, both preferred and common being of a par value of $100 per share. Of this capital stock $25,000 of preferred stock was sold for cash at par and $25,000 of the preferred stock and $450,000 of common stock was issued for the business and assets of a partnership composed of H. H. Miller and John C. Miller. The assets of the partnership included a negligible amount of machinery, consisting of an indiscriminate lot of experimental equipment having no particular value in itself plus certain patents and patent rights owned by the partnership, and a contract under which John C. Miller who had conceived, invented, and developed several inventions and patents was to assign and transfer to the petitioner all of the inventions and patents which he might acquire during his term of employment with the petitioner. The contract did not require John C. Miller to render services to the petitioner for any stated length of time. He, however, remained in the employ of the New Jersey corporation until some time in 1906.
*2333 The patents owned by the partnership and transferred to the corporation were four in number and are listed as follows:
| Number | Description |
| 543,950 | A machine for sterilizing and cooling liquids. Application filed Feb. 16, 1898. Patent granted October 17, 1899. |
| 678,891 | A process for sterilizing liquids. Application filed May 10, 1900. Patent granted July 23, 1901. |
| 678,892 | An apparatus for sterilizing liquids. Application filed May 16, 1900. Patent granted July 23, 1901. |
| 678,893 | An apparatus for sterilizing and cooling liquids. Application filed December 7, 1899. Patent granted July 23, 1901. |
The patents above referred to and designs and drawings paid in to the New Jersey corporation in exchange for $475,000 par value of its capital stock had a fair market value in 1901 of $124,375.
The New Jersey corporation operated with indifferent success for many years. The Miller Pasteurizing machine, which was the principal invention paid into the New Jersey corporation, was perfected during the years following 1901. During certain testing processes conducted by the New Jersey corporation with respect to the Pasteurizing machine in 1903 a very important*2334 development occurred which formed the basis of introducing, a short time later, a new process for manufacturing ice cream. During a test of the Miller Pasteurizer at Paulding, N.Y., in the spring of that year the cooling parts of the machine froze up and the frozen liquids ground out the top of the cylinder into the bowl that carried the milk. This frozen milk resembled ice cream. This accidental situation suggested to John C. Miller the possibility of manufacturing ice cream in the same way, that is, through the use of the same part of the Pasteurizing machine which generated the cooling power. In the fall of 1903 the ice cream freezer manufactured on the foregoing plan was demonstrated *250 in the company's factory and produced a very fine quality of ice cream. The first machines manufactured under this theory were upright machines for the purpose of bringing out the freezing theory that had been originally developed through the Pasteurizing idea. The original machine was a combination of the old idea which required the center beater being taken out to get the ice cream out of the machine. The demonstrations of this machine quickly convinced John C. Miller that he would*2335 have to get away from the unsanitary condition of going down into the can to get out the dasher. This brought out his idea of an apparatus for freezing ice cream with rotary horizontal drum, using circulating brine, which would be continuous in operation. An application for the patent under the newly invented ice cream freezer was filed with the United States Patent Office in 1904. At that time there was no similar machine on the market being built by anybody, or an ice cream freezer which was continuous in action and which would produce a frozen product in batches. The Miller invention was a new contribution to the ice cream industry. Most of the machines in use at the present time in production of ice cream in wholesale quantities are Miller machines or machines built upon the basic invention of Miller. Only minor improvements have been made between the date of early development, 1904, 1905, and 1906, and the present time.
During 1905, 1906, and succeeding years to 1918, the New Jersey corporation manufactured many ice cream freezers in accordance with the invention of John C. Miller. Other manufacturers copied the Miller idea and other applications for patents were filed. *2336 After interference proceedings in the Patent Office, Miller's claim to being the inventor was finally established and Letters Patent No. 945,570 were granted to the New Jersey corporation on January 4, 1910. Thereafter the New Jersey corporation brought infringement suits against a number of manufacturers which were not finally settled until many years later.
The first infringement suit was instituted against the Tyson Co. under date of October 2, 1911. Defendant filed several answers in ths case, which was not brought to trial due to the fact that the Tyson Co. was purchased by the Miller Pasteurizing Machine Co. and a compromise effected under a consent decree. Upon the acquisition of the assets of the Tyson Co. the New Jersey corporation acquired certain patents which had been rendered to Tyson on the construction of ice cream freezers. In 1913 the New Jersey corporation instituted a suit against the Chapin-Sacks Co. for infringement of its patent. This litigation dragged on for many years and was not brought to trial until 1920, at which time the court rendered judgment in favor of the petitioner thereby establishing the validity of the patent. Thereafter other infringers*2337 of the patent made *251 overtures to the petitioner and in 1926 it received from its principal competitor a cash settlement of $336,000; from another competitor it received $25,000; and from still another, $75,000.
From September 9, 1906, to June 18, 1912, the New Jersey corporation sold 1064 freezers at an aggregate selling price of $476,012.50. The ice cream freezers sold during the years 1910 to 1913, inclusive, ranged in price from $400 to $1,200, each, and the petitioner received a profit of not less than 33 1/3 per cent of the selling price, irrespective of the size of the machine.
The New Jersey corporation acquired from time to time patents on other machines relating to types of mixing machines connected with the ice cream business. It also acquired certain patents of no marked value, including one upon a checking machine to weigh skimmed milk.
The petitioner is an Ohio corporation with its principal office located at Canton, Ohio. It was organized on January 4, 1918, with the same capital stock as that of the Miller Pasteurizing Machine Co., organized under the laws of the State of New Jersey in September, 1901. It issued its stock to the stockholders of*2338 the New Jersey corporation share for share. The petitioner had the same corporate structure as the New Jersey corporation, the capital stock of the above companies carrying the same rights with respect to voting and dividends and no changes were made whatever with respect to the assets of the company; in fact, no entries whatsoever were made upon the books as evidencing any change having taken place. The stockholders of the petitioner were the same as the stockholders of the New Jersey corporation and the only reason for reincorporation under the laws of Ohio was as a matter of convenience with respect to attendance of the meetings, the company and most of its officers being located in Ohio. After the petitioner had acquired the shares of stock of the New Jersey corporation in the manner above indicated it took over the assets of the New Jersey corporation and the New Jersey corporation was then dissolved. The name of the petitioner was changed from that of The Miller Pasteurizing Machine Co. to The H. H. Miller Industries Co., under authorization granted in an amendment to the articles of incorporation dated December 20, 1920.
No dividends have ever been paid by the predecessor*2339 corporation or by the petitioner on either its common or preferred stock up to the present time. The records show, however, that upwards of $100,000 was expended by the two corporations in legal fees by the institution of patent infringement suits. The surplus of the petitioner is shown to have been $31,920.43 at December 31, 1909, and $48,544.03 at December 31, 1912. At December 31, 1916, the surplus was $116,279.25, and at December 31, 1917, $200,418.58. The surplus indicated *252 was before the deduction of any amount for the exhaustion of patents. The books of account show that patents have been carried at a value of $475,000 from December 31, 1910, to December 31, 1921.
The Commissioner computed the petitioner's invested capital for 1921 as follows:
| Capital stock | $497,500.00 |
| Surplus | 174,027.12 |
| Reserve | 106,500.00 |
| Total | 778,027.12 |
| Less: | |
| Adjustments Schedule G (patents) | 475,000.00 |
| Total | 303,027.12 |
| Less: | |
| 1920 income tax prorated | 31,240.11 |
| Adjusted invested capital | 271,787.01 |
The balance sheet of the petitioner as of December 31, 1920, is shown by the income-tax return filed for 1921 as follows:
| Assets | |
| Cash | $91.39 |
| Notes and accounts receivable | 97,092.34 |
| Inventory | 99,114.61 |
| Investments - Dominion of Canada bonds | |
| Permanent buildings | 159,730.18 |
| Machinery and equipment | 63,268.02 |
| Small tools, patterns, etc | 3,420.86 |
| Office furniture and fixtures | 1,657.82 |
| Automobiles | 6,585.00 |
| Patents | 475,000.00 |
| Deferred | 2,713.65 |
| 908,673.87 | |
| Liabilities | |
| Bank overdraft | $497.98 |
| Notes payable | 64,500.00 |
| Accounts payable | 63,404.65 |
| Accrued accounts | 2,244.12 |
| Reserves for doubtful claims | 1,500.00 |
| Reserves for doubtful accounts | 5,000.00 |
| Reserves for Federal taxes | 100,000.00 |
| Capital stock: | |
| Preferred | 47,500.00 |
| Common | 450,000.00 |
| Surplus | 174,027.12 |
| 908,673.87 |
*2340 OPINION.
LITTLETON: The first assignment of error is that the respondent excluded from invested capital for 1921, $124,375 representing the actual cash value on January 1, 1921, of intangibles consisting principally of patents paid in to the predecessor corporation in 1901 for $475,000 par value of capital stock. This amount is 25 per cent of the par value of the outstanding capital stock of the petitioner on January 1, 1921.
The patents which were paid in to the New Jersey corporation in 1901 for shares of stock of that corporation, and which had a value at the date paid in of $124,375, had all expired prior to 1921. No exhaustion for these patents was ever charged off on the books of account of the petitioner or its predecessor. Had such exhaustion been charged off, the surplus at December 31, 1920, would have been reduced by $124,375. The respondent has included in invested capital of 1921 the surplus shown by the books of account at December *253 31, 1920. By reason of this fact the respondent has in effect allowed the inclusion in invested capital of the $124,375 representing the value of patents originally paid in. In other words, the inclusion in invested*2341 capital of the amount claimed by the petitioner for intangibles paid in plus the corrected surplus (the book surplus reduced by $124,375 for exhaustion of patents) would not be an amount greater than that allowed by the respondent.
It is to be noted that the petitioner is a corporation which was organized in 1918, and which acquired the assets of the predecessor corporation. No contention was made by the petitioner that the rein-corporation of the business under Ohio laws in 1918 operated to increase the invested capital. We think that no such contention could validly be made, since section 331 of the Revenue Act of 1918 would have effectually barred the inclusion in invested capital of any appreciation in the value of assets. Upon the record made, the determination of invested capital by the respondent for 1921 is sustained.
The second point in issue is the contention of the petitioner that it should be allowed a deduction from gross income on account of the exhaustion of Patent No. 945,570, which was issued to the New Jersey corporation in 1910. The deduction claimed is based on a March 1, 1913, value which the petitioner sought to establish. But in seeking to establish*2342 a value as of March 1, 1913, the fact seems to have been overlooked that the patent in question was owned by the New Jersey corporation on that date and was only acquired by the petitioner through the acquisition of the stock of the New Jersey corporation in 1918 and the subsequent liquidation of that corporation prior to 1921. Since this was an acquisition subsequent to March 1, 1913, cost to the petitioner would be the basis on which an allowance for the exhaustion thereof would be computed and as to this cost we have no satisfactory evidence from which we can make a finding. No dividends were ever paid by the petitioner or its predecessor on either the common or preferred stock and the surplus of the petitioner at December 31, 1920, which included not only the earnings of the petitioner for 1918, 1919, and 1920, but also the accumulated earnings of the New Jersey corporation from 1901 to 1918, does not make a showing on which we could predicate a cost to the petitioner of the patent in question. It is, of course, true that the greater part of the litigation which was instituted by the petitioner or its predecessor on account of alleged infringements of this patent was settled*2343 in favor of the validity of the patent. It further appears, however, that while suits were begun as early as 1911 on account of alleged infringements, the first to be decided by the courts was in 1920 in which a Federal District Court held in favor of the petitioner. This decision was affirmed by the Circuit Court of Appeals in 1925, and the Supreme Court denied a petition *254 for a writ of certiorari in the same year. In 1926 the losing party in the aforementioned suit paid to the petitioner $336,000 on account of the infringements which had taken place and, subsequently, on the basis of this decision other parties, who had likewise been infringing upon the patent, made settlement, paying to the petitioner substantial amounts on account thereof. The foregoing events, however, happened well subsequent to the date with which we are here concerned. And, too, we are not overlooking the fact that the patent in question marked a decided change in the ice cream industry and that apparently the only successful manner in which rival concerns could meet the petitioner in competition was by infringing on this patent, thus indicating something of value. It is also true that substantial*2344 amounts were expended in the development and protection of the patent in question, both prior and subsequent to its acquisition by the petitioner.
While the foregoing facts may indicate a potential value attaching to the patent in question, they afford little help in arriving at its definite cost to the petitioner at the date acquired. In fact, we have no facts from which we can determine either the value of the patent at date of acquisition or the value of whatever stock may have been exchanged therefor. Accordingly, we can not do other than deny the petitioner's claim for a deduction on account of the exhaustion thereof.
Reviewed by the Board.
Judgment will be entered for the respondent.
SMITH, dissenting: I dissent from so much of the opinion of the Board as disallows any deduction from gross income for the exhaustion of Patent No. 945,570. The evidence establishes to my satisfaction that the patent had a cash value on March 1, 1913, of $400,000. It had a life of 13 years, 10 months, and 4 days from that date. The patent was the principal asset of value acquired from the New Jersey corporation. The patent had as great value in 1918 as on March 1, 1913, less*2345 the exhaustion sustained. Exhaustion was sustained at the rate of $28,915.68 per annum, which amount, in my opinion, is a reasonable allowance for exhaustion for 1921.
TRAMMELL agrees with this dissent.