*220 Decision will be entered under Rule 50.
In 1944 and 1947, petitioner became the exclusive licensee under certain patents by agreements, terminable without default only by petitioner upon written notice, and providing for royalty payments computed upon gross receipts. In 1950, petitioner and its licensors executed modification agreements which provided for the unconditional sale of the patents for agreed prices, the payment of which was to be made in installments. Held, by the execution of the modification agreements, petitioner acquired fixed costs for the patents, susceptible of depreciation. Held, further, the installment obligations of petitioner under the modification agreements did not represent borrowed capital under section 439, I.R.C. 1939, to be used in computing petitioner's excess profits credit under the statute.
*744 The respondent has determined deficiencies in petitioner's income and excess profits taxes as follows:
| Year | Amount |
| 1951 | $ 104,690.01 |
| 1952 | 86,898.80 |
*221 The deficiencies arise from respondent's disallowance of deductions for depreciation of certain patents and disallowance of the inclusion of certain sums as borrowed capital in the computation of petitioner's excess profits credit. Respondent allowed the deduction of certain payments with respect to the patents as business expenses by way of royalties. None of those payments were claimed by petitioner as deductions on its tax returns for the 2 years in question. Petitioner, instead of claiming deductions for royalties, claimed deductions for depreciation of the patents.
The issues here presented are: (1) Whether by modification agreements executed in 1950 petitioner acquired a fixed cost susceptible of depreciation for certain patents previously used under exclusive license agreements under which royalties were paid, and (2) whether the modification agreements created an outstanding indebtedness includible as borrowed capital in the computation of petitioner's excess profits credit.
FINDINGS OF FACT.
A stipulation of facts has been filed by the parties and is incorporated herein by this reference.
The petitioner is a corporation organized under the laws of the State of Nevada, *222 with its principal place of business at Los Angeles, California. It filed its corporation income tax return for the year 1951 with the collector of internal revenue, Los Angeles, and its return for 1952 with the director of internal revenue, Los Angeles.
At all times pertinent herein 80 per cent of the stock of petitioner was owned by I. J. McCullough and 20 per cent was owned by his brother, O. J. McCullough. I. J. McCullough and O. J. McCullough are sometimes hereinafter referred to as the McCulloughs.
*745 Since its inception in 1941 petitioner has been and is now engaged in the rendition of perforating and other highly specialized services to the oil-drilling industry. The business in which petitioner is engaged is highly competitive and approximately 75 per cent of such business is founded on a number of patents which it either owns or is licensed to use.
Prior to January 1, 1944, the McCulloughs were the owners of certain patents (hereinafter referred to as the bullet patents) governing the manufacture, use, and sale of bullet-like projectiles for the perforation of oil wells.
On January 1, 1944, petitioner and the McCulloughs entered into an agreement whereby petitioner*223 received an exclusive license to make, use, and sell devices manufactured in accordance with the bullet patents. The agreement provided, inter alia:
1.
The Licensors hereby grant to the Licensee, upon and subject to the conditions, covenants, restrictions and terms hereinafter contained, the full and exclusive right and license during the continuance of this agreement to make, use and sell throughout the United States, its territories and possessions, devices made in accordance or disclosed in the aforesaid patents set forth on Exhibit A for the full term of said patents and until the expiration date of the last of said patents.
2.
It is mutually understood and agreed that the license granted in Paragraph 1 hereof is granted subject to the conditions that it does not and shall not empower the Licensee, directly or indirectly, to license any other person or persons, natural or artificial, to use said patents.
* * * *
4.
The Licensee further agrees to keep books, records, and accounts of all work performed during the life of this agreement of all work done hereunder, and all such records or accounts shall at and during the usual business hours be open to the inspection of the Licensors*224 or their duly authorized representative.
5.
On or before the 15th day of each calendar month after the execution hereof and during the continuance of this agreement, the Licensee shall mail a statement to each of the Licensors containing the information required in Paragraph 4, hereof, showing all charges for use and sales by the Licensee under this agreement during the next preceeding [sic] calendar month.
6.
In consideration of the rights and licenses herein given and granted by the Licensors to the Licensee, the Licensee agrees to pay to the Licensors at the time of rendering the statement required by Paragraph 5 hereof, a royalty consisting of a sum equal to twelve and one-half per cent (12 1/2%) of the total *746 gross price charged by the Licensee for all gun perforating done and all sales of parts and equipment in accordance with the herein license and patents, and one-fourth (1/4) of the said royalty shall be paid to the Licensor O. J. McCULLOUGH and three-fourths (3/4) of the said royalty shall be paid to the Licensor I. J. McCULLOUGH.
7.
The Licensee shall have the right to terminate this agreement upon first giving ninety day notice in writing to the Licensors *225 to cancel and terminate this agreement together with all rights, licenses and obligations hereunder, provided, however, that no such termination or cancellation shall relieve the Licensee from the payment of any royalty due and payable to the Licensors at the time of such termination.
8.
In the event that either party shall violate any covenants of this agreement, the aggrieved party may give to the defaulting party written notice of such breach accompanied by sufficient particulars to reasonably enable the defaulting party to determine the alleged nature and extent of the breach, and if the defaulting party shall fail for a period of thirty days after the service of such notice to remedy such breach, the aggrieved party may, at its option, terminate and cancel this agreement and all of the rights and licenses of any defaulting party hereunder. The waiver of any particular breach or breaches by the aggrieved party shall not be deemed to constitute a waiver of any continuing breach or of any future breach by the defaulting party of this agreement.
On October 1, 1947, petitioner entered into an exclusive license agreement with Earl J. Robishaw and William G. Sweetman regarding several*226 patent applications (hereinafter referred to as the jet patents) governing the manufacture, use, and sale of shaped charges of explosives for the perforation of oil wells, devices sometimes known as jet perforators. The process of jet perforation of oil wells covered by the jet patents was not sufficiently developed at the time of the agreement to be commercially usable. Petitioner under the agreement undertook the responsibility and expense of further development of the jet patents. In all other material respects the agreement was similar to the agreement for the bullet patents except as to the amount of royalty, the length of periods for notice of termination, and the transferability of the license. The agreement makes no mention of the right to grant sublicenses.
Neither Robishaw nor Sweetman was an employee of petitioner on October 1, 1947.
In July 1948, each of the McCulloughs acquired a 25 per cent interest in the jet patents. At that time the jet patents were still not commercially usable.
On December 28, 1950, the McCulloughs and petitioner executed a document entitled "Modification Agreement" which provided:
Whereas, the parties hereto on the first day of January, 1944*227 did make and enter into an Agreement by which the [McCulloughs] sold to the [petitioner] *747 certain patents and patent applications listed on Exhibit "A" attached thereto; and
Whereas, said Agreement was termed a "License Agreement" and the parties thereto were referred to as Licensors and Licensee, respectively, although the Agreement was intended to be, and, in law, was actually an agreement of sale; and
Whereas, Paragraph 6 of said Agreement provided for payments to the [McCulloughs], which payments were termed "royalty", of 12 1/2% of the total gross price received by the [petitioner] for services and sales under the said patents and patent applications; and
Whereas, the parties are desirous of modifying said provision for payment and substituting therefor a fixed and determinable total remaining price to be paid by the [petitioner] in consideration for the sale of the said patents;
Now, Therefore, in consideration of the mutual promises of the parties hereto, IT IS AGREED AS FOLLOWS:
1. Paragraph 6 of said Agreement of January 1, 1944 is modified to read as follows:
"6.
"In consideration of the rights in and to the patents and patent applications transferred, assigned *228 and sold by the [McCulloughs] to the [petitioner], the [petitioner] hereby agrees to pay to the [McCulloughs], in addition to all other payments heretofore made hereunder, $ 20,000.00 per month on the 28th day of each calendar month, commencing on the 28th day of December, 1950, for a period of six years and one month. The last of said monthly payments shall be due and payable on the 28th day of December, 1956. One-fourth of each of said monthly payments, or $ 5,000.00, shall be paid to O. J. McCULLOUGH, and three-fourths of said monthly payments, or $ 15,000.00, shall be paid to I. J. McCULLOUGH. The parties are agreed that the total of these payments, $ 1,460,000.00, shall be the full remaining price to be paid by the [petitioner] for the complete and absolute ownership of the patents and patent applications described in Exhibit 'A'."
2. It is agreed by the parties hereto that any and all provisions of said Agreement of January 1, 1944 which are inconsistent with this Modification Agreement shall have no effect. Said Agreement of January 1, 1944 has been considered by the parties thereto as an absolute assignment or sale of the subject matter thereof. That Agreement together*229 with this Modification thereof shall be similarly construed hereafter.
On December 28, 1950, the parties to the jet patent agreement or their assignees entered into similar modification agreements, effect of which, inter alia, was to substitute the total price of $ 2,870,000 for the payment of a royalty. In all other respects the agreements were almost identical to the modification agreement relating to bullet patents.
Petitioner made all payments for the bullet patents due the McCulloughs under the modification agreement. Petitioner's gross sales of parts and services under the bullet patents, the royalty payable thereon which would have been paid under the agreement of January 1, 1944, the actual payments made under the modification agreement, and the excess of what royalty payments would have been paid under *748 the agreement of January 1, 1944, over actual payments for the years 1950 to 1958 are as follows:
| Year | Sales | Royalty | Actual payments | Excess |
| 1950 1 | $ 20,000 | ($ 20,000.00) | ||
| 1951 | $ 2,073,301.88 | $ 259,162.74 | 240,000 | 19,162.74 |
| 1952 | 2,311,565.79 | 288,945.72 | 240,000 | 48,945.72 |
| 1953 | 2,908,134.84 | 363,516.86 | 240,000 | 123,516.86 |
| 1954 | 3,140,828.54 | 392,603.57 | 240,000 | 152,603.57 |
| 1955 | 3,268,037.83 | 408,504.73 | 240,000 | 168,504.73 |
| 1956 | 3,948,232.27 | 493,529.03 | 240,000 | 253,529.03 |
| 1957 | 2,688,173.28 | 336,021.66 | 336,021.66 | |
| 1958 | 2,250,591.30 | 281,323.91 | 281,323.91 | |
| 22,588,865.73 | 2,823,608.22 | 1,460,000 | 2 1,363,608.22 |
Petitioner has made all payments for the jet patents due to the owners or assignees under the modification agreement. Petitioner has made no attempt to terminate the agreement and in 1952 made advances to one of the parties of payments due for the 5 years next ensuing. Petitioner's gross sales of parts and services under the jet patents, the royalty payable thereon if such royalty payments had been made under the agreement of October 1, 1947, the actual payments made under the modification agreement, and the excess of what royalty payments would have been made under the contract of October 1, 1947, over actual payments for the years 1950 to 1958 are as follows:
| Year | Sales | Royalty | Actual payments | Excess |
| 1950 1 | $ 14,000 | ($ 14,000.00) | ||
| 1951 | $ 2,391,904.25 | $ 239,190.43 | 168,000 | 71,190.43 |
| 1952 | 2,953,871.53 | 295,387.15 | 168,000 | 127,387.15 |
| 1953 | 3,323,230.48 | 332,323.05 | 168,000 | 164,323.05 |
| 1954 | 3,478,612.41 | 347,861.24 | 168,000 | 179,861.24 |
| 1955 | 4,012,038.67 | 401,203.87 | 168,000 | 233,203.87 |
| 1956 | 4,490,768.51 | 449,076.85 | 168,000 | 281,076.85 |
| 1957 | 3,799,971.39 | 379,997.14 | 168,000 | 211,997.14 |
| 1958 | 3,569,073.75 | 356,907.38 | 168,000 | 188,907.38 |
| 28,019,470.99 | 2,801.947.11 | 1,358,000 | 1,443,947.11 |
Petitioner incurred its obligations under the modification agreements of 1950 in good faith and for the purposes of its business.
Subsequent to the hearing and the filing of briefs in this proceeding, the parties filed a stipulation designated as "Stipulation With Respect to Definition of Issues" in which, among other things, it is stipulated:
5. Respondent concedes that should the Court find that petitioner is not entitled to deductions in the nature of depreciation or amortization, then petitioner should be permitted to deduct as "royalty" expense the amounts actually *749 paid out as such in each of the years in issue, which amounts are stipulated as $ 408,000.00 for each of the two years.
6. Should, however, the Court find that petitioner is entitled to deductions in the nature of depreciation or amortization by reason of the fact that the 1950 modification agreements created a fixed cost, then the parties request that the Court hand down a Rule 50 opinion in this regard so as to enable the parties to determine the remaining lives of the various patents involved or to otherwise determine the proper amount of the depreciation deductions.
OPINION.
The *232 first issue here presented is whether, as petitioner contends, sums paid in 1951 and 1952 by petitioner under the jet patent and bullet patent agreements of 1947 and 1944, respectively, as modified by the 1950 agreements, were paid to acquire depreciable capital assets of a fixed cost and, therefore, whether petitioner is entitled to deduct depreciation on the patents under section 23(l)(1) 1*233 of the 1939 Code; 2 or whether, as respondent has determined, the agreements as modified failed to accomplish a fixed price for the patents. Respondent has disallowed petitioner's claim for depreciation on the patents and in lieu of depreciation, has allowed petitioner a deduction in each of the taxable years of $ 324,000 as deductible royalties under the licensing agreements of 1944 and 1947 within the provisions of section 23(a)(1)(A). 3 It is now agreed that if petitioner is not to be allowed depreciation on the patents, it is to be allowed $ 408,000 as royalties paid in each of the taxable years.
Respondent does not contend that these patents are not depreciable capital assets, nor does he contend that petitioner did not purchase the patents. He insists, rather, that petitioner did not have a fixed cost basis for the patents susceptible of depreciation. Respondent has determined that the modification agreements of 1950 were of no effect for tax purposes because petitioner had already purchased the patents under the 1944 and 1947 agreements. With such an interpretation we do not agree. Whether, under our views expressed in Edward C. Myers, 6 T.C. 258">6 T.C. 258, the licensor-vendors had effected a sale of the patents is not material to the two issues we have here to decide. What*234 is material, we think, is that the modification agreements *750 of 1950 substituted for petitioner's then-existing obligation to make payments of royalties dependent upon gross receipts over the lives of the patents, new obligations to make payments of sums certain over specified shorter periods of time. Such substitution of obligations differing materially in extent and time are mutually supporting considerations giving rise to valid and enforceable contracts. See 6 Williston, Contracts, sec. 1826 (rev. ed.), and cases collected in note 2 thereto. The payments made under the modification agreements are directly attributable to the purchase of the patents.
We sustain petitioner's assignment of error on this issue, and hold that the respondent erroneously disallowed deduction of depreciation based upon the cost of the patents as fixed by the modification agreements of 1950.
The second issue presented is whether the agreements of 1944 and 1947, as modified in 1950, created outstanding indebtedness includible in petitioner's borrowed capital under section 439(b)(1). 4 Petitioner contends that the modification agreements of 1950 effected a revocation of its unilateral rights *235 of termination under the earlier agreements, established fixed prices for the patents and fixed dates of payment, and that, therefore, the agreements created outstanding indebtedness incurred in good faith and evidenced either by notes or conditional sales contracts. Respondent, however, contends that petitioner retained its unilateral rights of termination under the modification agreements and that, therefore, petitioner had no outstanding indebtedness thereunder includible as borrowed capital in the computation of its excess profits credit. Respondent also contends that the alleged indebtedness created by the modification agreements of 1950 was not evidenced by any of the instruments named in section 439(b)(1) of the applicable statute. Finally, respondent contends that petitioner did not enter into the modification agreements "in good faith for the purposes of the business."
*236 From the language used in section 439(b)(1), it is apparent that, in order for a taxpayer to include certain indebtedness in its borrowed capital for excess profits tax credit purposes, such indebtedness must be (1) an outstanding indebtedness, (2) must have been incurred in good faith for the purposes of the business, and (3) must be evidenced by one of the specified types of instruments named in *751 the statute. Satisfaction of requirements (1) and (2) named above is insufficient to bring an item of indebtedness within borrowed capital unless the further requirement is met, that the indebtedness is properly evidenced. This evidence must be in writing and of a specific kind, limited to the types of instruments enumerated in the statutory definition of daily borrowed capital.
We shall, therefore, first discuss whether the indebtedness created by the modification agreements was evidenced by one of the specific types of instruments specified in the applicable statute. If it was not so evidenced, it cannot be included in petitioner's borrowed capital for excess profits tax purposes. Although the modification agreements were in writing, it seems clear that the indebtedness created*237 thereby was not evidenced by a bond, bill of exchange, debenture, certificate of indebtedness, mortgage, deed of trust, or bank loan agreement. Petitioner does not contend that the indebtedness was evidenced by any of the types of instruments just named. However, petitioner does contend that the contracts entered into by the parties in the modification agreements were notes within the meaning of that term as used in the statute. Petitioner also contends that the transfer of the patents made to petitioner by the modification agreements for the considerations therein named represented conditional sales within the meaning of that term as used in the statute. We do not think that either of these contentions can be sustained.
We shall first discuss whether or not the modification agreements which created the indebtedness were notes within the meaning of the statute. The respondent, in his regulations interpreting section 719 of the so-called World War II Excess Profits Tax Law, which is substantially the equivalent of section 439 of the present statute, interprets the word "note" as "promissory note." Sec. 35.719-1, Regs. 112. Respondent makes no interpretation in his regulations*238 issued under the present statute. Sec. 40.439-1, Regs. 130. We think, however, that the word "note" as used in each of the statutory provisions means the same.
In Journal Publishing Co., 3 T.C. 518">3 T.C. 518, the taxpayer publishing company entered into a written contract agreeing to pay a competitor over a period of years, including the taxable year, the sum of $ 520,000, of which $ 50,000 was for certain assets and $ 470,000 was for the competitor's promise, within certain limits, to discontinue publication and not to resume publication of newspapers or otherwise compete. During the taxable year the daily average outstanding liability of the taxpayer to such competitor, as found by us, was $ 483,770.49. Based on the foregoing facts, we held that the liability of the taxpayer under the contract was not borrowed capital within the meaning of section 719, because the taxpayer's liability under *752 the contract was not evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust and, therefore, might not be considered in the computation of invested capital. In the Journal Publishing Co. case, in holding*239 against the taxpayer, among other things, we said:
If the contract in the instant case were to be construed as a promissory note, its fair market value would be includible in the gross income of the News Co. in the year in which the contract was made. However, this Court has held that "when evidence was introduced showing that the deferred payments were evidenced only by contract, where no notes, bonds, or other evidences of indebtedness other than the contract were given, such contract had no fair market value, and that the amounts of the deferred payments should be included in income when received." C. W. Titus, Inc., 33 B.T.A. 928">33 B.T.A. 928, 935. The authorities cited by petitioner do not go beyond confirming the essential correctness of the definitions of a promissory note as stated above. We are of the opinion that the contract in the instant case is not a "note" within the meaning of section 719(a)(1) of the Internal Revenue Code, as amended by the Second Revenue Act of 1940.
While, of course, it is true that the contract in the Journal Publishing Co. case was different from the contract evidenced by the modification agreements, nevertheless we*240 think that just as we held in that case that the contract therein involved was not a note within the meaning of the applicable statute, we must also hold here that petitioner's promises to pay under the contracts created by the modification agreements were not evidenced by a promissory note. We hold against petitioner on this contention.
Petitioner's next contention is that the modification agreements were conditional sales and, therefore, on that account the amounts in question are includible in petitioner's borrowed capital for excess profits tax credit purposes. We think the modification agreements do not evidence conditional sales. Section 40.439-1(f), Regulations 130, defines the term "conditional sales contract" as follows: "The term 'conditional sales contract' means a contract corresponding to a mortgage except that the transfer of title is made dependent upon the payment of the stipulated price." That the modification agreements here are not conditional sales contracts seems clear to us. No transfers of titles or other substantial rights were made "dependent upon the payment of the stipulated price."
In reading paragraph 1 of the modification agreements which modified*241 paragraph 6 of the original licensing agreements, paragraph 6 was changed in certain important respects and, among the changes, the following clause was included in it:
The parties are agreed that the total of these payments, $ 1,460,000.00, shall be the full remaining price to be paid by the [petitioner] for the complete and absolute ownership of the patents and patent applications described in Exhibit "A". [Emphasis supplied.]
*753 A similar provision except as to amount was contained in the modification agreement as to the jet patents. We do not regard the modification agreements as effecting conditional sales. We think they effected completed sales. No title was reserved by the transferors so far as we can see and petitioner did not impose any conditions as to payments, except to specify the time when they should be made. We do not sustain petitioner on this point.
For reasons above stated, we sustain respondent's determination that petitioner is not entitled to use the indebtedness created by the modification agreements of 1950 as borrowed capital under section 439.
Decision will be entered under Rule 50.
Footnotes
1. December only.↩
2. Under the modification agreement of Dec. 28, 1950, the fixed payment terminated December 1956. Under the prior license agreement of Jan. 1, 1944, the royalty payments would have continued until approximately 1968.↩
1. December only.↩
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(1) Depreciation. -- A reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) --
(1) of property used in the trade or business * * *↩
2. All section references are to the Internal Revenue Code of 1939, as amended.↩
3. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) Trade or business expenses. --
(A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *↩
4. SEC. 439. BORROWED CAPITAL.
(b) Daily Borrowed Capital. -- For the purposes of this subchapter, the daily borrowed capital for any day of any taxable year shall be determined as of the beginning of such day and shall be the sum of the following:
(1) The amount of the outstanding indebtedness (not including interest) of the taxpayer, incurred in good faith for the purposes of the business, which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, deed of trust, bank loan agreement, or conditional sales contract. * * *↩