*3216 1. Held, that a certain contract for the exclusive showing of certain theatrical attractions in the City of Detroit and which was transferred to the petitioner for a portion of its capital stock had cost the previous owner nothing within the meaning of section 331 of the Revenue Act of 1918 and is not to be included in petitioner's invested capital at any amount.
2. Held, that a certain leasehold transferred to the petitioner for a part of its capital stock cost the previous owner nothing and is not to be included in the petitioner's invested capital at any amount.
3. Assessment under section 328 of the Revenue Act of 1918 allowed.
4. The value of stock issued for a contract and a leasehold determined for the purpose of exhaustion allowances.
*587 This proceeding is for the redetermination of deficiencies in income and profits taxes of $5,060.67 and $7,370.71 for the fiscal years ended August 31, 1919, and August 31, 1920, respectively. The matters put *588 in controversy by the petitioner*3217 are: (1) Whether the respondent erred in refusing to include in invested capital for each year the amounts of $90,000 and $50,000, representing the amounts of capital stock issued by the petitioner for a contract for the exclusive privilege of showing certain theatrical productions in Detroit, Mich., for a period of 15 years, and for a 5 year lease on a theatre building in that city, respectively; (2) whether the respondent erred in refusing to allow the petitioner for each year deductions of $6,000 and $10,000 representing the aliquot parts of the exhaustion of the contract and the leasehold, respectively, based on the amount of stock issued therefor; and (3) whether the petitioner is entitled to have its profits taxes for both years computed under the provisions of section 328 of the Revenue Act of 1918. With respect to the first of the above mentioned matters in issue, the petitioner admits in its brief that inasmuch as the lease had cost the previous owner nothing it may not be included in invested capital.
FINDINGS OF FACT.
The petitioner was incorporated in June, 1918, under the laws of Michigan and has its principal office at Detroit. It was originally organized under*3218 the name of the Randolph Theatre Co. but immediately changed its name to that now borne by it. For the fiscal years ended August 31, 1919, and August 31, 1920, petitioner filed its income and profits-tax returns with the collector of internal revenue at Detroit.
During the years involved in this proceeding the petitioner had an outstanding capital stock of $150,000. Of this amount, $10,000 was issued to B. C. Whitney for cash and the remainder was issued him for a franchise and lease as set out below.
About June 14, 1918, the petitioner acquired from B. C. Whitney a certain contract or franchise for the exclusive right to show in the City of Detroit the theatrical attractions of Klaw & Erlanger for a period of 15 years. The petitioner issued $90,000 par value of its capital stock for the contract or franchise which was as follows:
This agreement, made this fourteenth day of May, 1918, by and between B. C. Whitney, of the City of Detroit, State of Michigan, party of the first part, and Alf Hayman, Klaw & Erlanger, of the City of New York, State of New York, parties of the second part, WITNESSETH:
WHEREAS, the party of the first part is the manager of the theatre known as*3219 the Detroit Opera House, in the City of Detroit, State of Michigan, and is desirous of securing the co-operation and services of the second party in booking attractions for the said theatre; and,
WHEREAS, the parties of the second part are engaged in the business of securing attractions for theatres and likewise in obtaining the privilege of theatres in order to book attractions therein, and in connection therewith are desirous of securing the exclusive right to book the aforesaid theatre and place attractions therein; and,
*589 WHEREAS, it is essential to the parties of the second part undertaking, at the request of the party of the first part, the booking of said theatre, that the right to book the same be exclusive and continuous for the period of this contract;
NOW, THEREFORE, In consideration of the premises and the sum of One Dollar, lawful money of the United States, by each of the parties hereto to the other in hand paid, the receipt of which is hereby acknowledged, and the covenants and promises herein contained, it is agreed as follows:
FIRST: The party of the first part hereby gives and grants unto the parties of the second part the sole and exclusive right*3220 and privilege for the term of fifteen years, beginning on or about August 1, 1918, to engage all plays and attractions for, and to book plays and attractions at, the aforesaid theatre, known as the Detroit Opera House, situated in the City of Detroit, State of Michigan.
SECOND: The party of the first part hereby agrees to accept and play at said theatre such attractions as the parties of the second part may engage, book or contract for him, and at such times as so booked; subject, however, to the immediate approval or disapproval, in good faith, of the party of the first part.
THIRD: The parties of the second part are hereby given the full, exclusive and sole control of the bookings for said theatre during the aforesaid term, and agree to use their best efforts to book proper and suitable attractions at said theatre during the term, and to use their best efforts to keep the time properly filled during the theatrical season, as warranted by the business; and agree not to book any attractions in any other theatre in said city during the existence of this agreement.
FOURTH: The party of the first part agrees not to book or play any attractions at said theatre except such as are*3221 engaged by or through the parties of the second part; and the party of the first part agrees to submit all applications, written or verbal, for time at said theatre, to the parties of the second part, and that he will not book any attractions of said theatre without the consent of the parties of the second part.
FIFTH: The party of the first part agrees to pay to the parties of the second part, in lieu of salary, and solely as compensation for their co-operation and services, as aforesaid, a yearly compensation which shall be a sum measured by and equal to forty (40%) per cent of the profits during the aforesaid term, said compensation to be paid at the close of each theatrical season.
SIXTH: It is understood and agreed that the earnings of said theatre each year shall be ascertained by deducting from the receipts of said theatre during each year the annual rental, which the said party of the first part has to pay for said theatre each year, and such other expenses incidental to the running of said theatre, to-wit: light, heat, advertising, license, salaries of staff in front of house, orchestra, stage hands and such expenses incidental in carrying out contracts made with the*3222 attractions playing in said theatre.
SEVENTH: The party of the first part agrees to do every thing in his power to run said theatre as economically as possible.
EIGHTH: This agreement shall not in any manner constitute or be construed as a partnership between the parties hereto, and the parties of the second part shall not, in any way, be liable or responsible for the payments of any sums of money, debts, contracts or other obligations in the operation of said theatre or its business, or the performance of the contracts made by the parties of the second part for the party of the first part; but the payment of the compensation *590 hereinbefore agreed is to be paid to the parties of the second part for their services and cooperation in booking attractions for said theatre, as aforesaid.
NINTH: Settlements under this agreement shall be made annually on the first day of June of each year, and in the event of any loss during any specific year, said loss is not to be carried as an item against the following year, but each year's business is to stand for itself.
TENTH: The party of the first part agrees to keep just and true books of account, in which there shall be entered*3223 in detail, all receipts of said theatre, as well as all expenses in the operation thereof during the term of this agreement; and true vouchers of each and every expense shall be kept, which books and vouchers shall at all times be accessible to the parties of the second part and their representatives, who shall be permitted to make copies thereof and extracts therefrom.
ELEVENTH: The party of the first part shall send to the parties of the second part weekly complete statements of receipts and expenditures, and at the end of each season a complete statement of the receipts and expenditures.
TWELFTH: The party of the first part is not to make any charge against or deductions from the profits of the said theatre for any improvements said party of the first part may make on said building, inside or outside; it being understood that the cost of replacing carpets, chairs, and other furniture in said theatre when required may be charged as an expense in the operation of said theatre.
THIRTEENTH: If for any reason this contract is violated before its expiration, by the party of the first part, or is terminated, he hereby gives the parties of the second part the right and authority, *3224 at their option, to cancel all attractions (and contracts therefor) booked for the unexpired term of this agreement, without waiving, however, any other rights or remedies in the premises, which said parties of the second part may have.
FOURTEENTH: This agreement shall apply to and bind the executors, administrators and assigns of the party of the first part, and all persons managing, operating or controlling the said theatre.
About June 4, 1918, the petitioner acquired from Whitney a certain 5-year leasehold, beginning August 1, 1918, covering a theatre building now known as the "New Detroit Opera House" and then known as the "Lyceum Theatre" located at Detroit, Mich. The petitioner issued to Whitney for the leasehold $50,000 par value of its capital stock. The lease was dated June 5, 1918, and was between Elizabeth Frelinghuysen of Tuxedo, N.Y., designated as party of the first part, and Whitney, party of the second part. A preliminary agreement to execute the lease had been entered into between these parties on April 25, 1918.
The leased premises are described as follows:
* * * The building known as the Lyceum Theatre, situated upon the rear of Lots G, H, I, J, K, *3225 L and M. Subdivision D of the West part of Block Seven (7), Brush Farm, on the East side of Randolph Street, City of Detroit, State of Michigan, including the entrance to said Lyceum Theatre, 182 Randolph St., the cellar underneath and the manager's office over said entrance, and including also the two stores known as Nos. 184 and 194 Randolph St., *591 Detroit, together with the basement, ground floor and the first floor above said stores, together with the boilers, steam heating apparatus, chairs, electric light and gas fixtures, and apparatus, the stage fixtures, machinery and scenery now in said premises belonging to said first party.
The lease provided for a total rental for the 5-year period of $81,000, payable in equal monthly installments of $1,350 each on the first day of each month in advance, commencing August 1, 1918. The lessee was to pay all water rents on the premises, all charges for gas and electricity and for the theatrical license.
The lease also provided that:
Said demised premises are to be used exclusively for theatrical purposes, and the said second party shall conduct the same as a first class theatre, producing Klaw & Erlanger's and other first*3226 class attractions.
An almost identical provision was contained in the preliminary agreement of April 25, 1918.
Under the lease, the party of the second part had the option of a 5-year renewal upon the giving of proper notice. The lease also contained provisions relating to the manner of determining the amount of rental for the period of renewal in event the parties were unable to agree.
In the preliminary agreement, dated April 25, 1918, A. L. Erlanger agreed to guarantee the performance of such covenants of the lease as were binding on the lessee and signed the following provision at the end of the lease dated June 4, 1918:
In consideration of the letting of the premises in the foregoing instrument described, and for the sum of One Dollar to me paid, I do hereby become surety for the punctual payment of the rent, and performance of the covenants in said instrument mentioned, to be paid and performed by the party of the second part therein named; and if any default shall at any time be made therein, I do hereby promise and agree to pay unto the party of the first part named in said instrument, the said rent and arrears thereof that may be due, and fully satisfy the conditions*3227 and covenants of said instrument and to pay all damages that may occur by reason of the non-fulfillment thereof, without requiring notice or proof of the demand to be given or made.
Prior to the organization of the petitioner and its acquisition of the lease on what was then known as the "Lyceum Theatre" and now known as the "New Detroit Opera House," Whitney and others had operated the Detroit Opera House, located at 17 Campus, Detroit, and about 3 1/2 blocks away. Whitney had to give up the Detroit Opera House because the building had been sold and it was planned by the purchaser that a department store building be erected on the site of it. On account of war conditions, the construction of the new building was never begun. About 1920 the theatre building was leased by the Shuberts and David Nederlander and is now being used *592 for legitimate stage productions. At the time Whitney gave up the Detroit Opera House, the "Lyceum Theatre," now the "New Detroit Opera House," at 182 Randolph Street, was the only available location suitable to his purposes. A rental of $25,000 per year was paid for the Detroit Opera House, which had only about one-half the capacity of the*3228 "New Detroit Opera House."
Sam Levey and one Gillingham had been associated with Whitney in the operation of the theatre at the Detroit Opera House, which Whitney had been operating for over 20 years. Prior to that time Whitney had operated a theatre alone and also in partnership with his father and E. D. Stair. About 1875 Whitney's father entered the theatrical business in Detroit, presenting legitimate stage productions, and, when about six or seven years old, Whitney started in with his father by passing programs. From that beginning, Whitney worked up through the various phases of the business.
Klaw & Erlanger are the representatives for the booking or circuit contracting for such producers as Ziegfeld, Dillingham, Belasco, Cohen, Harris, Tyler, George White, and others. Klaw & Erlanger have had priority on the best producers ever since they have been in business and are one of the principal booking agencies or distributors of the country. It was because of that fact that the lessor had the provision inserted in the lease restricting the use of the theatre to the productions of Klaw & Erlanger and other first-class attractions.
The attractions presented by the petitioner*3229 after June 4, 1918, were obtained under the contract from the Erlanger Booking Exchange. Klaw & Erlanger had similar arrangements with certain other individuals in other cities such as Cleveland, Baltimore, Washington, Columbus, Indianapolis, and Toronto, Canada. In practically every town or city of any size throughout the United States and Canada they either have such an arrangement or have their own theatre, which gives them a complete circuit throughout the United States and Canada for the presentation of the theatrical attractions which they control.
The only other organization which controls the booking of legitimate stage attractions for a similar circuit of theatres is the Shuberts. The Shuberts produce a considerable number of their attractions and take care of some producers that Klaw & Erlanger can not handle. Most of the attractions obtained by the petitioner under the contract with Klaw & Erlanger had had a long season in New York before going on the road and appearing in the provincial cities, as they were called. Some of the attractions obtained by the petitioner through Klaw & Erlanger, such as the "Follies" or the *593 "Scandals," were annual attractions, *3230 whereas others came about every two years.
For several years Whitney and his father had been exhibiting Klaw & Erlanger attractions under similar arrangements with that firm. Their relations with Erlanger have always been very friendly and intimate and the franchise was given to Whitney because of these relations, the services or favors rendered by him over a period of 30 years, including those rendered during the early days of the Klaw & Erlanger syndicate, as well as for the present and future advantages and benefits expected from such an arrangement. Erlanger always in the past had favored Whitney over others in the granting of the franchise.
Various attempts were made by others to obtain from Klaw & Erlanger the franchise obtained by Whitney and turned over to the petitioner. In 1917, when a rumor was current in Detroit that Whitney would be unable to obtain a renewal of the franchise, Erlanger assured him that, regardless of who desired to obtain the franchise, he (Whitney) could have it as long as he wished.
Whitney paid no cash bonus for the lease on the New Detroit Opera House, but was able to get it at the rental agreed upon because the house had been used previously*3231 for the operation of a cheaper priced theatre and the lessor anticipated that with the Klaw & Erlanger attractions being shown in it its value as well as that of the neighboring property would be increased. The lessor's anticipations were realized, as rents all around the theatre were practically doubled when the petitioner began operating under the Klaw & Erlanger franchise. The petitioner, with its Klaw & Erlanger attractions, catered to that class of the public which is less limited in its spending, while the other operators catered to those who were more limited in their spending.
It would not have been possible for the lessor to have leased to another with as high-class attractions, since there were no other franchises obtainable except the Shuberts, who were already taken care of in their own theatre. From time to time Whitney was approached with offers to purchase the lease and franchise. Levey and Gillingham wanted to continue in business with him and to buy it, but he would not entertain any offers at that time.
In 1921 Whitney, finding it necessary to obtain additional funds, sold 375 shares of his stock in the petitioner corporation to Levey and Falk at par for*3232 cash. Levey would have paid more than par if he could have secured control of the corporation.
*594 The petitioner's balance sheets were as follows at the dates indicated:
| ASSETS | LIABILITIES | |
| June 15, 1918 | ||
| Capital stock | $150,000.00 | |
| Klaw & Erlanger franchise | $90,000.00 | |
| Lease | 50,000.00 | |
| Bank | 10,000.00 | |
| 150,000.00 | 150,000.00 | |
| August 31, 1919 | ||
| Capital stock | 150,000.00 | |
| Klaw & Erlanger franchise | 90,000.00 | |
| Reserve for depreciation - Same | 6,000.00 | |
| Lease | 50,000.00 | |
| Reserve for depreciation - Same | 10,000.00 | |
| Improvements, leased premises | 20,006.41 | |
| Reserve for depreciation - Same | 4,001.28 | |
| Carpets | 559.50 | |
| Surplus | 155.71 | |
| E. M. Freylinghuysen | 4,050.00 | |
| Bills payable | 25,950.00 | |
| Rent | 1,350.00 | |
| B. C. Whiteney | 44,306.71 | |
| Bank | 769.88 | |
| Box office and cash | 3,291.51 | |
| Klaw & Erlanger | 3,281.86 | |
| Gregory Mayer & Thom | 196.50 | |
| Mrs. B. C. Whitney | 32.82 | |
| R. B. Potter | 32.82 | |
| 206,992.50 | 206,992.50 | |
| August 31, 1920 | ||
| Capital stock | 150,000.00 | |
| Klaw & Erlanger franchise | 90,000.00 | |
| Reserve for Depreciation - Same | 12,000.00 | |
| Lease | 50,000.00 | |
| Reserve for Depreciation - Same | $20,000.00 | |
| Improvements, leased premises | $20,006.41 | |
| Reserve for depreciation - Same | 8,002.56 | |
| Surplus | 10,974.86 | |
| E. M. Freylinghuysen | 1,350.00 | |
| Bills payable | 22,800.00 | |
| Rent | 1,350.00 | |
| B. C. Whitney | 65,849.62 | |
| Bank | 157.16 | |
| Box office and cash | 523.78 | |
| Goldberg & Jaginaw | 750.00 | |
| Leon Krim | 2,000.00 | |
| Gregory Mayer & Thom | 126.08 | |
| Mrs. B. C. Whitney | 32.82 | |
| R. B. Potter | 32.82 | |
| 228,763.06 | 228,763.06 | |
| August 31, 1921 | ||
| Capital stock | 150,000.00 | |
| Distribution, capital assets | 60,000.00 | |
| Klaw & Erlanger franchise | 90,000.00 | |
| Reserve for depreciation - Same | 18,000.00 | |
| Lease | 50,000.00 | |
| Reserve for depreciation - Same | 30,000.00 | |
| Improvements, leased premises | 20,006.41 | |
| Reserve for depreciation - Same | 12,003.84 | |
| Surplus | 1,212.01 | |
| Bills payable | 15,600.00 | |
| B. C. Whitney | 4,603.62 | |
| Bank | 124.85 | |
| Box office and cash | 343.05 | |
| 225,946.89 | 225,946.89 |
*3233 Whitney devoted practically his entire time to the business of the petitioner during the years involved in this proceeding. For the year ended August 31, 1919, he received a salary of $4,000 and for the year ended August 31, 1920, his salary was $10,000 and his commissions amounted to $7,072.33.
In his determination of the deficiencies involved in this proceeding the respondent has refused to include in petitioner's invested capital the amounts of $90,000 and $50,000, representing the par value of stock issued for the franchise and the leasehold, respectively. He has also refused to allow as deductions for exhaustion of the franchise and the leasehold the amounts of $6,000 and $10,000, respectively.
The petitioner's net earnings without the deductions for exhaustion of leasehold and franchise were as follows:
| Year ended August 31, 1919 | $21,078.53 |
| 1920 | 27,826.33 |
The only dividend paid by the petitioner during the taxable years was that of $4,922.82 paid on August 11, 1919.
*595 The stock issued for the franchise and the leasehold had values of $90,000 and $50,000, respectively at the time of issuance.
OPINION.
TRAMMELL: The petitioner concedes*3234 that this case comes within the provisions of section 331 of the Revenue Act of 1918, but contends that it is entitled to include in its invested capital the amount of $90,000, representing the par value of the stock issued to Whitney for the Klaw & Erlanger franchise which was given to Whitney as a bonus for services or favors rendered by him over a period of 30 years, on the ground that that amount represented the cost to the previous owner. It is urged that the value of the franchise was presumably the value of the services, and that such value represented the cost of the franchise to Whitney. The evidence shows that Klaw & Erlanger considered that it was a valuable asset to them for Whitney to have their franchise. The evidence shows that it is the policy of Klaw & Erlanger to continue their franchises with the same individuals in each town. Whitney testified that the franchise was handed down to him for practically the services rendered in the early days of the formation of the Klaw & Erlanger syndicate and because of his long and friendly association with Erlanger. He also stated that he regarded the franchise in the nature of a bonus for services or favors rendered over*3235 a period of 30 years. No evidence was offered to show the nature or the extent of the services rendered by Whitney or the value of such services. While Whitney might have regarded the lease as a bonus for past services or favors, Klaw & Erlanger might have regarded it otherwise and considered it to be an arrangement which would bring future favors, services and profits. From a consideration of all the evidence we are not convinced that the franchise was given to Whitney entirely for past services, but that other considerations entering into the transaction were the present advantages to be derived by Klaw & Erlanger, the future benefits which they expected, the custom of continuing franchises once given, and the long and friendly associations between Whitney and Erlanger. In view of this fact, we can not find that Whitney acquired the franchise for services or that the value of the franchise is represented by the services rendered. This being true, the franchise had no cost to Whitney within the meaning of section 331 which could be included in the petitioner's invested capital.
Inasmuch as the petitioner admits in its brief that the lease cost Whitney nothing, and that it*3236 can not be included in invested capital under the provisions of section 331 of the Revenue Act of 1918, at any value, consideration of the action of the respondent in excluding this item from invested capital is unnecessary.
*596 The petitioner contends that if the value of the franchise does not represent its cost to Whitney, it is impossible to determine its exact cost and this would bring the petitioner within the provisions of section 327(a), entitling it to the right of having its tax liability computed under the provisions of section 328.
It is also alleged that because of abnormalities in its income and invested capital for each of the years the petitioner's profits tax for each year should be computed under the provisions of section 328.
From the evidence, we are satisfied that the lease and franchise acquired by the petitioner for stock were worth $140,000, the franchise being worth $90,000 and the lease $50,000. This amount is excluded from invested capital under section 331. In other words, all the petitioner's assets which it acquired for stock were excluded from invested capital and its invested capital is based on only the amount of $10,000 which is*3237 represented by cash paid in. While the exclusion of any amount from invested capital by section 331 in and of itself does not create an abnormality under section 327, when such a large percentage of the value of assets acquired for stock is excluded, we think that the case is brought within the scope of section 327.
From a consideration of all the evidence, we are of the opinion that the stock issued by the petitioner for the franchise had a value of at least $90,000 at the time issued and that the stock issued for the lease had a value of at least $50,000 at the time of issuance. For each year the petitioner is entitled to deductions of $6,000 and $10,000 representing exhaustion of franchise and leasehold, respectively.
Reviewed by the Board.
Further proceedings will be had under Rule 62(c).