*1480 1. March 1, 1913, value of a patent and patent applications determined.
2. Held that deductions for exhaustion should be spread over the average life of the several patents involved rather than over the life of the last patent granted.
*676 The respondent determined deficiencies for the periods and in the amounts as follows:
| 1920 | $40,367.74 |
| 1921 | 50,147.27 |
| 1922 | 1,923.01 |
| 1923 | 2,221.18 |
| Period from Sept. 15th to December 31, 1924 | 1,361.94 |
| 1925 | 2,419.40 |
| 1926 | 2,595.26 |
| 1927 | 7,244.61 |
All of the several original issues were waived by petitioners except their claims for depreciation deductions based on the March 1, 1913, value of patents and patent applications. The respondennt, by way of affirmative defense, in Docket No. 15383 alleges that if the depreciation deductions claimed are allowed the basis on which he allowed special assessment for 1920 and 1921 will be destroyed and that a further hearing may be necessary. On motion of the respondent the hearing in the first instance*1481 was limited to the issues not involving special assessment.
FINDINGS OF FACT.
Petitioner, Florence Manufacturing Company, was a Massachusetts trust, organized in 1919 for the purpose of taking over the business of a corporation of the same name which was organized in 1866. Petitioner, Prophylactic Brush Company, is a Massachusetts corporation, organized in 1924 to take over the business of petitioner, Florence Manufacturing Company. As these proceedings involve *677 no question arising out of the reorganization, the two corporations and the association above mentioned will be referred to indiscriminately as "the petitioner" or "the petitioners."
The business of petitioner at all times pertinent hereto has been the manufacture and sale of tooth, hair, military, and lather brushes, and miscellaneous items.
Prior to 1909 petitioner manufactured tooth brushes by the hand-drawn method. Under that method holes for the tufts of bristles were drilled in one end of the brush handle and then slots were cut on the other side to the base of the holes. The handles were then placed in a clamp, and the operator pushed a loop of fine wire through the slot and hole at one end. *1482 Opening up the loop with the fingers of the left hand, the operator placed it in a small tuft of bristles which had been measured out by a knot-picking machine operated by a foot treadle. The loop was drawn about the tuft, as near the center as possible, and the wire was drawn through the slot carrying the tuft into position in the hole. This operation was continued until a row of bristles was completed, then the wire was cut off and a new row started, and so on until the whole brush was drawn. Portruding wires were then laid in the slots and the slots filled with cement, after which the brushes were sanded, scraped, and polished.
In the hand-drawn method, bone handles were mostly used. Pyroxyline, as a material, was better than bone in that the handles ran more uniform, it was nonporous, was less likely to split, and was easier to stamp. It was also more readily obtainable than bone. However, pyroxyline handled brushes could not successfully be manufactured by the hand-drawn method because the stiffening of the cement placed in the slots destroyed the pyroxyline.
An operator working in petitioner's factory could draw a gross of brushes in a nine-hour day. However, the*1483 operators could not stand the work at that pace and as early as 1900 petitioner was finding it increasingly difficult to procure operators to work in the factory. Many brush handles were sent out to the operators to be drawn in their homes, in which cases the production would vary from a half gross to two and a half gross per week for each operator.
In 1903 and again in 1905 petitioner sent representatives to Europe to investigate brush-making machines. A study was also made of patents in this country relating to such machines. It was found that patents were held in Germany and also by a concern in the United States which might block the development of the sort of machine petitioner desired to produce. Accordingly, petitioner *678 in 1906 procured an assignment to it of the German patent and at an undisclosed date obtained a license from the holder of the domestic patent. The way was thus cleared for the development of a tufting machine to meet petitioner's needs.
Petitioner produced its first tooth brush tufting machine in 1908, filed application for a patent thereon May 8 of that year, and obtained a patent, No. 924194, on June 8, 1909. At various times petitioner*1484 acquired certain other United States patents which were used in connection with the manufacture of tooth brushes, among which were patents numbered 778361, 928548, 928549, 1125187, 1125188, and 1125189.
In the use of the machine patented June 8, 1909, eight brush handles, or backs, were mounted on a revolving disc in pairs. The disc was moved so that a brush back was brought into position under a drill which made the tuft holes. The backs were drilled one at a time, and while one was being drilled, the one next to it, having been drilled previously, was being tufted. The tufting mechanism automatically picked out tufts of the proper size and forced them into the drilled holes and stapled them into place. As each pair of brushes was finished it was necessary for the operator to stop the machine and turn the brush-carrying disc a quarter turn and position a new pair of brush backs under the drilling and stapling mechanism. This machine was the first practical automatic tooth brush machine produced in the United States.
Prior to 1912 petitioner's superintendent completed a tooth brush machine which was an improvement on that above described. An application for a patent thereon*1485 was filed January 9, 1912. The Patent Office required a separation of claims and on January 19, 1915, two patents, numbered 1125187 and 1125189, were issued covering the machine.
In this machine the brush backs were carried on an endless chain and automatically positioned for drilling and tufting so that operation was continuous and it was not necessary, as in the case of the earlier machine, to stop operations for the positioning of each new pair of backs. This was the first machine adapted to making brushes with three rows of bristles. The prior machine could drill and tuft only brushes having an even number of rows. Three-row brushes were the most popular.
The stapling method of making brushes in the patented machines, as distinguished from the hand-drawn method, made the use of pyroxyline handles practicable. The relative use of bone and pyroxyline under the two methods is shown by the following tables:
| Hand-drawn method | Machine method | |||||
| Year | Pyroxyline | Bone | Total pieces | Pyroxyline | Bone | Total pieces |
| 1909 | [*] | 1,589,277 | 1,643,751 | 386,545 | 15,683 | 402,228 |
| 1910 | [*] | 1,536,127 | 1,576,094 | 316,561 | 59,698 | 376,259 |
| 1911 | 8,540 | 1,617,187 | 1,625,727 | 382,706 | 221,466 | 604,172 |
| 1912 | 145,989 | 1,313,266 | 1,459,255 | 927,907 | 101,330 | 1,029,237 |
| 1913 | 2,808 | 1,290,060 | 1,292,868 | 1,304,709 | 55,929 | 1,360,638 |
| 1914 | 11,376 | 1,116,563 | 1,127,939 | 1,511,154 | 21,777 | 1,532,931 |
| 1915 | 37,800 | 636,755 | 674,555 | 2,129,249 | 17,427 | 2,146,676 |
| 1916 | 6 | 636,538 | 636,542 | 3,307,111 | 16,908 | 3,324,019 |
| 1917 | 389,129 | 389,129 | 5,367,326 | 7,369 | 5,374,695 | |
| 1918 | 236,228 | 236,228 | 7,571,360 | 7,528 | 7,578,888 | |
| 1919 | 104,935 | 104,935 | 9,333,070 | 5,024 | 9,338,094 | |
| 1920 | 8,833,727 | 8,833,727 | ||||
| 1921 | 9,001,393 | 9,001,393 | ||||
| 1922 | 11,392,513 | 11,392,513 | ||||
| 1923 | 12,664,408 | 12,664,408 | ||||
| 1924 | 10,293,368 | 10,293,368 | ||||
| 1925 | 11,023,909 | 11,023,909 | ||||
| 1926 | 11,183,806 | 11,183,806 | ||||
| 1927 | 12,329,241 | 12,329,241 |
*1486 *679 In the hand-drawn method the operator could not always exactly center the loop of the tuft of bristles, and this made it necessary to cut the bristles a little longer than they would be in the completed brush, and inequalities in length were corrected by trimming. The patented machines exactly centered the staples on the tufts and thus required no extra length for subsequent trimming. This difference in the two methods resulted in a saving in the cost of bristles of 4 cents per dozen tooth brushes.
The saving in labor costs in 1913 by the use of machines, as compared with the hand-drawn method, amounted to 18 cents per dozen tooth brushes.
In 1913 petitioner had in operation ten machines, of which only five were of the fully automatic type.
With the advent of brush-making machines petitioner believed that it would shortly be in a position to supply a much larger market than existed at that time. As a part of its search for a market, a survey revealed that less than one-third of the population of the United States was using tooth brushes. With the hope of increasing the number of users of brushes, petitioner decided upon a campaign of education of school children*1487 in matters pertaining to oral hygiene. Literature and charts were prepared by petitioner and furnished to school teachers for use in teaching children the need for and proper use of tooth brushes. The literature so distributed contained no advertising matter. In a short time teachers began to send in requests for brushes to distribute to children at prices lower than those on the market because the children could not afford to pay the regular prices. Petitioner thereupon withdrew its "seconds" *680 from the open market and furnished them to teachers, who in turn sold them at cost to the school children. The natural run of "seconds" was insufficient to supply this demand and so to follow up the work, petitioner made brushes and stamped them "seconds." Such brushes were sold at a loss, which petitioner charged to development expense.
Prior to 1913 most of the tooth brushes used in this country were imported and were sold at a lower price than domestic brushes. Petitioner was of the opinion that by the use of its machines it would be able to meet the competition of foreign brushes.
In 1913, in anticipation of an increased market which it hoped to develop through its*1488 advertising campaign and the lowering of costs, petitioner built and equipped a five-story building as a cost of $50,000.
The number of machines in use was gradually increased by petitioner from three in 1909 to forty-six in 1927. With the use of the machine patented in 1909, fifty knots or tufts per minute could be produced. The machine patented in 1915 produced an average of 90 knots per minute. This latter type of machine was subsequently improved so that in 1924 petitioner had one machine that turned out an average of 200 knots per minute. The number of higher-speed machines was increased to four in 1925, twelve in 1926, and twenty in 1927.
Each hand operator required 15 square feet of floor space. Each tufting machine occupied 42 square feet. The more rapid production by the machines over the hand method resulted in some saving of floor space. Selecting 1913 as a typical year, the petitioner had 9 machines in operation at the beginning of the year, and added one which operated for five months in that year, which on the basis of a full year is the equivalent of 9.41 machines. These machines, occupying a floor space of 394.22 square feet, produced 113,387 dozens of*1489 brushes. A hand operator could produce a gross a day, which on the basis of forty three weeks per year - which was petitioner's average - would be 3,096 dozens. On this basis 37 hand operators would be required to produce the 113,387 dozens turned out by the machines, and that number of operators would occupy 555 square feet. Thus the use of machines resulted in a saving of about 29 per cent of floor space.
The following table shows sales, income and profit per dozen of tooth brushes manufactured by petitioner and sold under the trade name "Prophylactic." The sale of this brand of brushes constituted the bulk of petitioner's business.
| Year | Dozens sold | Amount | Operating profit per dozen before depreciation | Operating profit per dozen after depreciation |
| 1909 | 152,112 | $248,119.45 | $0.11 | $0.09 |
| 1910 | 154,754 | 252,837.07 | .12 | .11 |
| 1911 | 163,869 | 275,968.64 | .18 | .16 |
| 1912 | 183,781 | 295,271.91 | .12 | .19 |
| 1913 | 175,471 | 325,996.94 | .14 | .12 |
| 1914 | 210,716 | 341,451.44 | .19 | .18 |
| 1915 | 216,742 | 402,247.23 | .24 | .23 |
| 1916 | 325,140 | 565,128.31 | .49 | .48 |
| 1917 | 436,668 | 952,082.79 | .79 | .78 |
| 1918 | 591,309 | 1,460,812.16 | .86 | .85 |
| 1919 | 716,793 | 1,948,768.95 | .81 | .80 |
| 1920 | 704,634 | 2,076,970.29 | .65 | .64 |
| 1921 | 731,307 | 2,318,807.53 | .82 | .80 |
| 1922 | 801,675 | 2,361,917.21 | .93 | .91 |
| 1923 | 893,424 | 2,608,983.92 | .75 | .73 |
| 1924 | 812,829 | 2,369,822.55 | .43 | .40 |
| 1925 | 917,553 | Not given. | Not given. | Not given. |
| 1926 | 830,082 | 2,453,097.57 | .78 | .76 |
| 1927 | 1,021,449 | 2,850,617.09 | .72 | .70 |
*1490 *681 The earnings of petitioner from all sources for the years 1909 to 1923, inclusive, were as follows:
| 1909 | $59,496.96 |
| 1910 | 69,329.85 |
| 1911 | 63,406.12 |
| 1912 | 77,010.44 |
| 1913 | 58,714.23 |
| 1914 | 90,943.39 |
| 1915 | 126,184.79 |
| 1916 | 262,487.50 |
| 1917 | $438,573.26 |
| 1918 | 637,690.59 |
| 1919 | 737,137.55 |
| 1920 | 565,405.37 |
| 1921 | 650,732.88 |
| 1922 | 805,838.35 |
| 1923 | 767,363.09 |
The capital invested by petitioner, without the inclusion of any amount for intangibles, at the beginning of each of the above years was as follows:
| 1909 | $525,422.15 |
| 1910 | 542,912.81 |
| 1911 | 566,242.66 |
| 1912 | 583,648.78 |
| 1913 | 614,659.22 |
| 1914 | 627,373.45 |
| 1915 | 672,316.84 |
| 1916 | 752,501.63 |
| 1917 | $959,599.66 |
| 1918 | 1,333,144.03 |
| 1919 | 1,742,167.77 |
| 1920 | 2,016,877.33 |
| 1921 | 2,315,708.15 |
| 1922 | 2,705,554.61 |
| 1923 | 3,138,780.08 |
The average earnings of the Florence Manufacturing Company (Corporation) for the years 1905 to 1908, inclusive, equaled approximately 8 per cent of the capital invested in the business without including any amount for intangible assets.
Prior to 1921 petitioner had very little competition in so far as domestic brushes were concerned. In that year*1491 a company commonly known as the Rubberset Company built machines which were practically identical with petitioner's machines. A suit for infringement of patents was filed in January, 1922. The defendants admitted *682 infringement and a consent decree was entered against them in that year. In 1927 the tooth brush known as the "Dr. West" brush began to be manufactured in this country. Prior thereto it had been imported. In 1923 a Toledo concern invented a brush machine and offered it to petitioner.
In 1913 the manufacture and sale of tooth brushes constituted about 50 per cent of petitioner's business. By 1917 it had increased to about 80 per cent.
At various times petitioner acquired certain registered and unregistered trade-marks, secret processes, and trade names. Its registered trade-marks included "Pro-phy-lac-tic," "Dental Plate," "Twin Luxuries," "Cosmeon," "P. S.," "Sir Prize," "Dux," "Rational," "Goodsense," "Operle Cream," "Keep-clean," "Floreloid." It also owned a registered trade-mark consisting of circles with arrows, with the words "Brush your upper teeth downward and your lower teeth upward. Not this way." The sentence "A clean tooth never decays" *1492 was also a registered trade-mark of petitioner. Petitioner's unregistered trade-marks included the following: "Florence," "Gilt Edge," "Monogram," "Nevershed," "Paragon," "DeLuxe," "Standard," "Stranzit," "Lionite," "Prophylactic Penetrator."
During the period 1904 to 1916 petitioner spent $634,841.83 in advertising. Of this amount, $471,088.10 was expended in the period from 1909 to 1916. The entire amount so spent was charged to expense.
During the taxable years petitioner's good will was a valuable asset.
The fair market value at March 1, 1913, of the patent granted in 1909 and the patent applications pending on March 1, 1913, was $865,000.
Respondent has determined petitioner's net income in all years without the allowance of any deduction for exhaustion of patents.
OPINION.
ARUNDELL: Petitioners claim that the patent issued in 1909 and the patent applications pending on March 1, 1913, had a value on that date of $1,750,000, and that deductions for exhaustion should be allowed on that value. The value claimed is the amount fixed by petitioner's witness, Boyle, who was the only witness called upon to testify as to value. Boyle had been connected with petitioners*1493 in various capacities since 1897. In 1913 he was sales manager, later treasurer, and for several years prior to 1930 he was president. He reached his valuation on the basis of estimates that in five years after 1913 sales would be doubled and that savings effected through the use of machines would increase to 50 cents per dozen of tooth brushes. *683 Sales for 1913 amounted to approximately 221,000 dozens. Doubling this figure and applying the 50 cent estimated saving gives $221,000, which the witness capitalized at 10 per cent thus, reaching a figure of $2,210,000. This he reduced by 20 per cent to take care of contingencies, and gave the resulting figure of $1,750,000 as his opinion of the value of the patent and pending applications.
Petitioners cite , and , as requiring our acceptance of the opinion of value expressed by witness Boyle, "unless there are facts in the record clearly to show that the valuation was in error." The Boggs & Buhl decision is based upon the supposition that the Board "disregarded the only positive*1494 and direct evidence as to the value" of good will, but it recognizes the rule that the Board may "reject expert testimony and reach a conclusion in accordance with its own knowledge, experience and judgment." We do not understand this decision to mean that where we are unable to accept the conclusion of a witness we must have knowledge of the subject matter acquired outside the record. Obviously it would be error for us to base a conclusion on facts outside the record, save perhaps such as come within the rule of judicial notice. As we read the decision, it means to state the same rule as in the Bonwit Teller case, namely, that we may adopt a value other than that fixed by a witness "provided that there were sufficient basis in the record for the value adopted." In , which involved the valuation of good will, the court said:
It is urged that no witness testified as to the value of good will in 1913. In the absence of an actual sale, such testimony of value can be but an opinion, and can only be formed by taking into account the same financial history as the Board had before it, and applying some*1495 such formula as that approved by the Tax Bureau. The absence of opinion testimony, is not, therefore, important.
See also ; ; .
In our opinion the valuation claimed can not be justified on the facts existing and known at March 1, 1913. While it is true that petitioners have been tremendously successful, it does not appear that the full measure of their success was visible on March 1, 1913. Moreover, it appears that a substantial part of petitioners' income is properly attributable to intangibles other than patents. There are in evidence briefs and memoranda filed with the respondent in support of petitioners' claims for special assessment in which petitioners represented that they had extremely valuable good will and trade names, trade-marks, and secret processes. The present record does not contradict those assertions.
*684 The conclusion expressed by the witness is based in part on his estimate that production would be doubled in five years after 1913. At the*1496 same time he had planned and had in mind an extensive advertising campaign, which was put into effect and was successful. Between 1909 and 1916 the sum of $471,088.10 was spent in advertising petitioner's products. It thus appears that the estimate of production on which the valuation was based was to depend on the success of advertising rather than on the capacity of the patented machines. From 1909, when the first patented machine was put into operation, to 1912 the production had increased from 170,498 dozens to 207,374 dozens, an increase of 21 per cent, or at an average rate of a little over 5 per cent a year. Contrasted with this past history, petitioners' witness testified that he expected production to increase 100 per cent in the next five years, or at an average rate of 20 per cent a year. While there is evidence that improvements in the machines were expected to result in increased speed of operation, the facts known at March 1, 1913, do not warrant any such step-up in production as estimated by the witness.
Likewise, it appears that the estimated saving of 50 cents per dozen was an overoptimistic estimate and not warranted by the known facts. Prior to 1913 the*1497 saving effected had averaged only about 23 cents per dozen, and in 1913 it was 22 cents, including the estimated 4 cents saved in the cost of bristles. According to one computation of petitioners, savings in 1917 and 1918 amounted to only 16 cents per dozen, and on the calculation prepared in connection with the present proceedings the total savings were 22.9 cents for 1917 and 26.7 cents for 1918. We think it not unreasonable to assume that an increase in savings would follow from improving the brush-making machines and increasing production, but the evidence does not establish any reasonable ground for believing that the saving would be more than doubled at the end of five years.
We are also unable to agree with the witness' method of capitalizing earnings to reach a value. In the few cases in which earnings in excess of a reasonable return on tangibles have been capitalized for the purpose of valuing intangibles, it has been customary to use a rate of not less than 15 per cent.
The evidence does, however, satisfy us that at March 1, 1913, the patents and pending applications had a substantial value. The machine patented in 1909 was the only automatic brush-making machine*1498 in this country. The monopoly obtained by the possession of that patent gave petitioners a distinct advantage over manufacturers using the hand method of making brushes. At March 1, 1913, it had been demonstrated that the use of the machine would materially lower costs and enable petitioners to meet the competition of foreign-made *685 brushes. It had also been demonstrated at that date that machine production could be increased. It was reasonably evident that, with the improvements being made, some of which had been completed in 1912, the hand method would in time be entirely displaced by the machines. At March 1, 1913, the machines patented first had been in use about four years and the improved machine for about a year. The average annual production of those machines was something over 10,000 dozens of brushes per machine. According to the testimony of the former president, petitioner was able to build and put into operation an average of about two additional machines per year. As petitioners' product was a staple commodity for which there was an established market, and it was a fair assumption that its field would expand as costs were lowered, it was justified in*1499 anticipating that it would have need for the installation of additional machines. On the basis of the performance of the machines in operation at March 1, 1913, and allowing for increased production as the result of further improvements, and taking into consideration the rate at which additional machines could be built, it was possible to predict with reasonable certainty the production that could be expected in the future. It was also known at March 1, 1913, that savings in the cost of manufacture amounting to about 22 cents per dozen had been effected through the use of machines, and, assuming a reasonable increase through the lowering of overhead as a consequence of improving the machines, it was not unreasonable to expect that there would be some increase in the amount of the savings to be effected. While anticipated savings and increased production are proper elements to be taken into consideration, a prospective purchaser of patents would not look at them alone in fixing his price. The value of a patent lies in the amount of profits it will bring to its owner. In determining in the present case what a willing buyer might be expected to offer for the patents, the anticipated*1500 savings must be translated into terms of profits, which requires that they be reduced by such factors as the cost of manufacturing the patented machines, and the costs of their operation and maintenance. A prospective purchaser would also take into consideration the period over which profits might be expected to be realized and discount those of future years to their present worth. The profits realized prior to March 1, 1913, were susceptible of calculations, and on the basis of past performance it was possible to forecast what production and profits might be expected in the future.
But even if it be conceded that savings alone are a proper measure of value, as contended by petitioner, the facts known at March 1, 1913, would not support the value claimed. On the basis of established production and savings, with a reasonable allowance for increased *686 production through improvements, the total savings to be expected, discounted to present worth, would be between $500,000 and $600,000. On the same basis, but allowing for an increase in savings to the amount upon which the valuation witness based his calculations, gives a figure slightly in excess of $1,000,000.
Considering*1501 all the evidence in the light of known facts at March 1, 1913, and giving effect to the profits and the increases in production and savings that the evidence indicates might reasonably be expected over the life of the patents, it is our opinion that $865,000 represents the fair market value at March 1, 1913, of the 1909 patent and patent applications pending on that date.
Petitioners contend that the period over which exhaustion deductions are allowable is seventeen years from January 19, 1915, when patents were granted on improvements to the brush-making machine and for which applications were pending at March 1, 1913. In view of the fact that the claim is for exhaustion deductions on the value of the original patent, granted June 6, 1909, as well as the applications pending on March 1, 1913, and that the evidence was directed to both and not limited to the patents issued in 1915, we are of opinion that the deductions should be spread over the average life of the patents, which will be seventeen years from March 23, 1912. See *1502 , and cases there cited.
Decision will be entered under Rule 50 in each of the proceedings except Docket No. 15383, which will be restored to the general calendar for further hearing under Rule 62.