*729 In 1933 petitioner entered into a contract with the Sunbeam Co., under the terms of which the latter was granted the exclusive right to manufacture and sell machines under petitioner's patents for the full term of the patents, subject to payment of specified royalties. Sunbeam was granted an option to purchase the patents at any time during the life of the contract for $135,000 and upon exercise of the said option the purchase price was to be reduced by all royalty payments made prior thereto. During 1933 and 1934 petitioner received royalty payments under the contract and the amounts thus received were reported by it in its income tax return as royalty income. During the taxable year 1935 Sunbeam continued to make royalty payments until June 13, at which time it exercised the option to purchase the patents. All royalty payments made prior to that date were credited against the purchase price, Sunbeam paid the balance due and petitioner assigned the patents to Sunbeam. Held:
(a) Payments received by petitioner up to the time the option was exercised on June 13, 1935, constitute royalty income and payments received subsequent to that time constitute proceeds from the sale*730 of its patents;
(b) Petitioner is subject to surtax as a personal holding company under section 351 of the Revenue Act of 1934 and is liable to the 25 percent penalty for failure to file a personal holding company return; and
(c) Petitioner was not carrying on or doing business in 1935 within the meaning of the statute and is not subject to excess profits taxes under section 702 of the Revenue Act of 1934.
*1304 This proceeding was brought to redetermine deficiencies in petitioner's taxes and a delinquency penalty for the year 1935 in the total amount of $9,179.66, apportioned as follows: Income tax, $194.02; personal holding company surtax, $7,188.51; and delinquency penalty, $1,797.13. In the answer to the amended petition the respondent made a claim for increased deficiencies, the total amount claimed *1305 being $14,016.38, apportioned as follows: Income tax, $5,872.80; personal holding company surtax, $5,530.20; excess profits tax, $1,230.83; and delinquency penalty, $1,382.55. The issues presented*731 are as follows: (1) Whether certain amounts of money, or any part thereof, received by petitioner during the taxable year constituted royalties on patents owned by it, as claimed by respondent, or proceeds from the sale of the patents, as contended by petitioner; (2) whether petitioner is subject to a personal holding company surtax; (3) whether petitioner is liable for a delinquency penalty for failure to file a personal holding company return; and (4) whether petitioner is subject to an excess profits tax. Petitioner also alleged as error respondent's disallowance of a deduction in the amount of $1,000 representing expenses incident to liquidation. Petitioner presented no evidence or argument on this last issue and it will be regarded as abandoned.
FINDINGS OF FACT.
The petitioner, an Illinois corporation, was organized in 1927 to acquire and develop certain household refrigerating machine patents and to manufacture and sell such machines. In the first year of its organization petitioner built and sold refrigerating machines under its patents, but was unsuccessful in meeting the competition of the larger companies engaged in that field. Thereafter petitioner sought to dispose*732 of its patents and in 1928 entered into a contract with the Indian Motorcycle Co. whereby the latter made an initial down payment of $10,000 and was granted an option to purchase the patents within one year for an additional amount of approximately $225,000. At the end of the year the Indian Motorcycle Co. returned the patents to petitioner without exercising its option.
Under date of July 10, 1929, petitioner entered into a contract with the Sunbeam Electric Manufacturing Co., sometimes called the Sunbeam Co., whereby petitioner granted it the exclusive right to manufacture, sell, and use electric refrigerators under petitioner's patents for the full term of the patents. The Sunbeam Co. agreed to pay petitioner quarterly a certain specified royalty per machine sold, the royalty per machine to be decreased as the number of machines sold increased.
Under date of March 30, 1933, effective as of January 1, 1933, petitioner and the Sunbeam Co. entered into a supplemental agreement modifying and amending the contract dated July 10, 1929, and providing that the rate of royalties on machines sold by the Sunbeam Co. from and after December 31, 1932, would be 2 percent of the billing*733 price. The supplemental contract also granted the Sunbeam Co. *1306 an option to purchase petitioner's patents, which option provision is as follows:
It is expressly agreed that Sunbeam shall have the right to, and Rotorite hereby grants to Sunbeam an option, to purchase, during the term of said agreement of July 10, 1929, the Letters Patent and the applications for Letters Patent referred to in "Exhibit A" attached to said agreement of July 10, 1929, together with any improvements thereon, applications for Letters Patent and Letters Patent obtained at any time subsequent to July 10, 1929, by Rotorite with reference to the electric refrigerating machines aforesaid, all for the sum of One Hundred thirty-five thousand dollars ($135,000.00), plus interest at the rate of five percent (5%) per annum, figured quarterly on the unpaid balance thereon from January 1, 1933, until the principal amount aforesaid is paid. In the event Sunbeam exercises its option of purchase, it will in writing notify Rotorite to that effect, and Sunbeam shall thereupon be credited, upon said purchase price and interest aforesaid, with all royalties paid by Sunbeam to Rotorite between January 1, 1933, and*734 the date of such purchase. The unpaid balance, if any, of said purchase price thereupon shall be due and payable. Said royalty payments are first to be credited against the interest on the unpaid balance from the date of the last payment, and the remainder of said royalty payments are to be credited to said principal until the latter is fully paid. Upon the exercise of said option as aforesaid, and the full payment of the purchase price above set forth, Rotorite shall by proper instruments transfer and convey all of said Letters Patent and applications for Letters Patent to Sunbeam, and by proper assignment vest full title to said Letters Patent and applications for Letters Patent in Sunbeam.
During 1933 and 1934 the Sunbeam Co. paid royalties to petitioner in the respective amounts of $16,767.08 and $50,819.97, all of which was deducted by Sunbeam in its income tax return as royalty expenses and reported by petitioner as royalty income.
A meeting of petitioner's board of directors was held in December 1934 for the purpose of considering a proposed amendment to its articles of incorporation to reduce the call price of its preferred stock. At this meeting the chairman explained*735 that the corporation was in the process of liquidation and that the total amount of money that would be available would be less than the call price of the outstanding preferred stock. By resolutions of the board of directors and the stockholders, the call price of the preferred stock was reduced from $110 to $85 per share. This action became effective January 8, 1935, when the Secretary of State of Illinois issued a certificate so amending the articles of incorporation. The figure of $85 per share was an estimate of the equity represented by the preferred stock. To protect the preferred stockholders in the event that the estimate of $85 per share was not accurate, the common stockholdings were adjusted to correspond with the preferred stockholdings. In order to facilitate liquidation of petitioner, the preferred stockholders deposited their stock certificates with Guy A. Hull, as trustee, to hold until the call price had been paid, after which the certificates were to be transmitted to petitioner for cancellation.
*1307 From January 1 to August 16, 1935, the Sunbeam Co. paid petitioner the aggregate amount of $80,556.81, which completed all payments necessary to entitle*736 it to an assignment of the patents. All payments received by petitioner prior to April 30, 1935, were entered in a "Royalties Received" account in the amounts and on the dates as follows:
| February 4 | $125.19 |
| February 8 | 5,079.01 |
| March 7 | 10,926.28 |
| April 8 | 17,460.40 |
| Total | 33,590.88 |
All payments received by petitioner after April 30, 1935, were entered in a "Sales of Patents" account in the amounts and on the dates as follows:
| May 8 | $17,452.59 |
| June 8 | 14,753.60 |
| July 15 | 8,994.87 |
| August 14 | 5,763.87 |
| August 16 | 1.00 |
| Total | 46,965.93 |
Petitioner's cost basis of the patents was $80,000. The depreciation allowed or allowable through December 31, 1934, amounted to $34,971.75, leaving an unrecovered cost basis as of January 1, 1935, in the amount of $45,028.25. Petitioner entered the payments received subsequent to April 30, 1935, in its "Sales of Patents" account so that they could be applied against its unrecovered cost of the patents which on that date amounted (after deducting depreciation from January 1 to April 30 in the amount of $1,727) to $43,301.25.
On June 13, 1935, Sunbeam sent the following letter to the secretary-treasurer of*737 petitioner:
This is to advise you that we wish to exercise our option to purchase the Rotorite Patents upon completion of the stipulated royalty payment. We expect that this will pay out in the June shipments, although orders have been slumping off a bit and it is possible that we might not be able to pay out before July.
On the last check which we will send you for royalty payments we will hold out $1 and send you an additional check for this amount. This will cover the payment for royalties as far as our book value is concerned.
We do not know how the Rotorite Corporation will handle the royalty payments on their books, but for our purpose here we are going to set up the value of the patents at $1.
At regular intervals during 1935 the Sunbeam Co. sent petitioner a form of credit memorandum showing the shipments of machines made during the preceding period, the billing price therefor, and the *1308 computation of 2 percent of the billing price. A check for the 2 percent of the billing price would accompany the credit memorandum. The credit memorandum which accompanied the payment received by petitioner on August 14, 1935, is as follows:
| Units | Amount | |
| Gross Sales | 7,912 | $315,533.46 |
| Returns and Allowances | 22 | 5,477.68 |
| Net | 7,890 | 310,055.78 |
| 2% Royalties | 6,201.12 | |
| Less Amount to Balance | 461.41 | |
| Due as per contract | 5,739.71 | |
| Interest to 8-14-35 | 25.16 | |
| Check enclosed for $5,763.87 | $5,764.87 |
*738 The amount "due as per centract" in the above memorandum was determined by deducting all prior payments from the maximum purchase price of the patents as specified by the contract between the parties. This amount was $461.41 less than would have been due if the payment had been made on the basis of 2 percent of the billing price of the machines sold. The $1 withheld by Sunbeam from the August 14, 1935, payment was sent to petitioner under date of August 15, 1935, the letter of transmittal stating that it was the balance due on the patent assignments. Upon receipt thereof petitioner assigned all its interests in the patents to Sunbeam.
It was the practice of the Sunbeam Co. to write down on its books the value of patents owned by it to $1. All of the payments made by the Sunbeam Co. to petitioner in 1935 up to and including August 14, 1935, were entered on the books of Sunbeam under a "Royalties Refrigerator" account, and the $1 payment made on August 15, 1935, was entered on a "Refrigerating Patents" account.
The only activities of petitioner from and after June 30, 1934, were receiving moneys from the Sunbeam Co. under the contract as amended and distributing such moneys*739 to its preferred stockholders. On January 1, 1935, the only assets held by petitioner were the patents subjected to the contract as amended and a small amount of cash. The payments received by petitioner from the Sunbeam Co. during 1935 were turned over to Guy A. Hull, as trustee, who in turn distributed the money to the preferred stockholders. During that year the preferred stockholders were paid $85 per share for their preferred stock and the preferred stock certificates were delivered to petitioner and canceled. At the end of the calendar year 1935 the sole remaining asset of petitioner was $8,772.48 cash on hand. This amount was withheld from its stockholders to enable it to meet taxes and expenses of final liquidation.
*1309 Petitioner did not file a personal holding company surtax return for 1935.
In its income tax return for 1935 the Sunbeam Co. deducted as royalty expenses the amounts entered in its "Royalties Refrigerator" account. The respondent objected to this treatment of the payments and as a consequence the Sunbeam Co. subsequently capitalized the payments.
In its income and excess profits tax return for 1935 the petitioner reported royalty income*740 in the amount of $33,590.88, representing the payments received from Sunbeam between January 1 and April 30, 1935. The remainder of the payments received subsequent to April 30, 1935, in the amount of $46,965.93, were reported as the gross sale price of the patents and after deducting its cost basis thereof it reported capital gain amounting to $3,664.68. In the notice of deficiency the respondent, after making several minor adjustments which are not here involved, determined a deficiency in income tax in the amount of $194.02, a personal holding company surtax, under section 351 of the Revenue Act of 1934, in the amount of $7,188.51, and a 25 percent delinquency penalty for failure to file a personal holding company return. In the amended petition it is alleged that the respondent erred in determining that any part of the income received during the calendar year 1935 constituted royalty income and that all the payments received from the Sunbeam Co. should have been treated as proceeds from the sale of its patents. In the answer to the amended petition the respondent alleges that petitioner received royalty income in the amount of $80,555.81, which represents all of the payments*741 received from Sunbeam during 1935 except the last $1 payment received on August 15, 1935. The final payment of $1 is treated as the selling price of the patents and a loss on the sale of the patents is shown in the amount of $43,300.25. In respect of the said loss it is alleged that the allowable deduction is limited to $2,000 under section 117(d) of the Revenue Act of 1934.
OPINION.
TURNER: The respondent now concedes that the payments made after June 13, 1935, amounting to $14,759.74, should not be treated as royalties. His position is that the letter of June 13, 1935, constituted notice by the Sunbeam Co. of the exercise of its right under the contract between the parties to become the purchaser of the patents, that the payments made prior to that date were royalties and the payments thereafter made constituted the selling price of the patents. The petitioner, on the other hand, still contends that all of the payments received in 1935, amounting to $80,556.81, must be treated for income tax purposes as the selling price of the patents and no part of such payments may be treated as royalties.
*1310 Both parties agree that under the contract the selling price of*742 the patents was not a fixed amount but was the maximum amount agreed to, reduced by such amounts paid under the contract as properly may be regarded as the payment of royalties. The petitioner agrees that the payments made in 1933 and 1934 were royalty payments and that they are not affected by the subsequent exercise by the Sunbeam Co. of its right to purchase the patents. With respect to 1935, however, it is claimed that inasmuch as Sunbeam did exercise its right to purchase the patents in that year, all payments made in 1935, including the payments made prior to the exercise of the right to purchase, became a part of the purchase price. In support of this proposition, petitioner relies on , and in further support thereof cites, among others, ; ; ; ; and .
In *743 , the taxpayer had reported all payments made during the year in which the option was exercised as the selling price of the property. The respondent increased the selling price by the amount of royalty payments made in preceding years but made no change with respect to the treatment of the payments made in the year in which the option was exercised. Accordingly there was no issue before us as to the character of the payments made in the year the option was exercised, and that case does not support the claim of the petitioner in the instant case. To the extent that the payments were in issue, however, we decided that they were royalty payments and not a part of the selling price of the property. It is thus apparent that Indian Creek Coal & Coke Co. gives support to the claim of the respondent rather than the petitioner.
In ,, and , there was an adjustment of salaries of the taxpayers prior to the close of the taxable year, the taxpayers refunding to their employers a portion of the amounts previously received by them*744 during the taxable year as salaries. It was held that the salary income of the taxpayers was the net amount received during the year. As the respondent points out in his brief, those cases make no determination as to the nature of income; they merely have to do with the amount of income received. Here the amount of the payments received is not in dispute. Those cases are not in point.
Under the contract between the Sunbeam Co. and the petitioner, the Sunbeam Co. had the right to use the patents belonging to the petitioner upon the payment of a specified royalty. It had a further right to become a purchaser through the exercise of an option, the *1311 price to be paid to be determined by subtracting the amount of the royalties previously paid from a maximum purchase price specified in the contract. The nature of the payments in the instant case was fixed by the parties themselves and so long as the patents belonged to the petitioner and there was no exercise on the part of the Sunbeam Co. of its right under the contract to purchase and acquire them as its own, the payments were royalties. *745 , is clearly not in point. There the parties, prior to the close of the taxable year in which the payments in question were made, contracted specifically as to the allocation of the said payments between principal and interest, while in this case there was no subsequent contract and the nature of the payments remains as fixed and determined by the terms of the contract existing when they were made. Neither is the situation here affected by the rule laid down by the Supreme Court in In that case the Court decided only that certain items of gross income were to be reported as such for the taxable year in which received. The character of the items as gross income was not in dispute. Here the situation is exactly the reverse. The question is not as to the period for reporting income but rather the character or nature of payments received.
On first impression this case seems to have some resemblance to ; affd., *746 . In that case the taxpayer, in years prior to the taxable year, had received certain amounts of money under an option to purchase certain of its property, which payments were to be applied upon the purchase price in case the option should be exercised. In the taxable year the option was surrendered without purchase, and it was held that the payments in question were income in the year of surrender. In reaching our conclusion, however, we specifically distinguished cases involving the question presented in the instant case, as follows:
* * * Cases involving royalties are distinguishable. Royalties have been held to be income at the time received where they represent a payment for the right to remove or use some of the property even though they are to be applied against the purchase price. The owner, of course, offsets this income by depreciation and depletion deductions which permit him to recover his basis taxfree despite the fact that the entire amount of the royalties is included in income. Here the payments were not of that character. * * *
In connection with the above quotation, see *747 , and
The petitioner seeks to avoid the conclusion that by reason of the letter from the Sunbeam Co. on June 13, 1935, the contract between the parties became a contract of sale and purchase by pointing to *1312 the language contained in the letter. It stresses particularly the first paragraph, reading as follows:
This is to advise you that we wish to exercise our option to purchase the Rotorite Patents upon completion of the stipulated royalty payment. We expect that this will pay out in the June shipments, although orders have been slumping off a bit and it is possible that we might not be able to pay out before July.
While the message thereby conveyed was not couched in words as definite as it might have been, there is no doubt in our minds that it was intended as the notice provided for in the contract between the petitioner and Sunbeam; nor is there any doubt in our minds that the petitioner accepted it as such. Furthermore, the fact that the Sunbeam Co., in keeping with its consistent practice of writing down patents to the amount of $1, entered on its books*748 all of the payments with the exception of $1 as the payment of royalties is no more controlling than the entries made on the petitioner's books designating payments received prior to April 30, 1935, as royalties and those received after that date as the selling price of the patents. The contract between the parties, and not such book entries, is controlling. It is accordingly held that the payments received up to June 13, 1935, represented royalties and the payments received thereafter constituted the selling price of the patents.
It is obvious, and there appears to be no contention to the contrary, that the patents were capital assets and the respondent is sustained in his claim that the deduction in respect of the loss sustained is limited to $2,000 by the provisions of section 117(d), supra. The petitioner is entitled, however, to depreciation on the patents up to the date of sale.
Our next question is whether the petitioner is subject to surtax as a personal holding company imposed by section 351, supra, and further, whether it is liable to a 25 percent penalty for failure to file a personal holding company tax return. A personal holding company is defined in section*749 351(b)(1) as any corporation if "at least 80 per centum of its gross income for the taxable year is derived from royalties, dividends, interest, annuities, and * * * gains from the sale of stock or securities * * *." The facts show that from and after June 30, 1934, the only activities of petitioner were the receiving of the payments from the Sunbeam Co. under the contract and the distributing of the amounts so received to its preferred stockholders. We have just held that the payments received by the petitioner from the Sunbeam Co. from January 1 to June 13, 1935, were royalties. It is thus apparent that substantially all, if not all, of the income of the petitioner during the taxable year was royalties and the petitioner falls within the definition of a personal holding company within the meaning of section 351(b)(1), supra.
*1313 The petitioner contends, however, that even though the payments received in 1935 were in the nature of royalties, it had no undistributed adjusted net income within the meaning of section 351, supra, and is not therefore liable to the tax imposed by that section. In support of this contention it points to the distributions made during*750 the year to its preferred stockholders, claiming that the said distributions were "dividends paid during the taxable year" within the meaning of section 351(b)(2)(C). According to the facts the petitioner was in process of liquidation. In December preceding it had taken steps to reduce the call price for its preferred stock from $110 to $85 per share. This act became effective on January 8, 1935, when the Secretary of State of Illinois issued a certificate so amending its articles of incorporation. During 1935, the taxable year, the petitioner made distributions to the holders of preferred stock amounting to $85 per share and the preferred stock certificates were delivered to petitioner and canceled. After such distributions petitioner had on hand cash in the amount of $8,772.48; it had no other assets. This amount was withheld from its stockholders to enable it to meet taxes and expenses of final liquidation. There is no showing that it was retained to retire indebtedness incurred prior to January 1, 1934. The petitioner, pointing to the language of section 351 of the Revenue Act of 1936 and section 27(f) of that act dealing with the corporation credit for dividends paid, *751 contends that such part of the distribution made to the preferred stockholders as is properly chargeable to earnings or profits is to be treated as dividends paid within the meaning of section 351(b)(2)(C), supra. This interpretation of the term "dividends paid during the taxable year" rests not upon the provisions of the Revenue Act of 1934, but upon the provisions of the Revenue Act of 1936; the Revenue Act of 1934 contained no such provision. We have previously considered the question as to whether or not the term "dividends paid during the taxable year" as that term is used in the Revenue Act of 1934 included distributions in liquidation and reached a conclusion contrary to the contention of the petitioner here. . We find nothing in the arguments advanced by the petitioner to indicate that the term was misconstrued. Cf. ; affd., .
With respect to the penalty for failure to file a personal holding company return, the petitioner argues that all requirements in that respect were met when the petitioner filed its corporate income tax return. *752 The question here presented was considered by the Board and decided contrary to the views of the petitioner in , and we find nothing in the arguments advanced which has not been considered and decided. *1314 It is accordingly held that, inasmuch as no personal holding company return was filed, the imposition of the penalty in respect thereto is mandatory.
With respect to the liability of petitioner for excess profits taxes under section 702 of the Revenue Act of 1934, the record shows that after June 30, 1934, its activities consisted of receiving the payments from the Sunbeam Co. and distributing them to its stockholders. It engaged in no other activities. Such activities do not constitute carrying on or doing business within the meaning of the act so as to make it subject to the capital stock tax, ; Kingkade Hotel Co.v. Jones, Fed.Supp. (U.S. Dist. Ct., W. Dist. of Okla., June 26, 1939); and Lyon Lumber Co. v. Harrison, Fed.Supp. (U.S. Dist. Ct., N. Dist. of Ill., June 15, 1939), and since it*753 is not subject to the capital stock tax, it is not subject to the excess profits tax. .
Reviewed by the Board.
Decision will be entered under Rule 50.
MURDOCK, dissenting: The agreement between the petitioner and Sunbeam gave to Sunbeam an option to purchase the patents for the sum of $135,000, and further provided that if Sunbeam exercised its option to purchase, all royalties therefore paid should be credited upon the purchase price. Those provisions gave to the payments a dual character. They might be royalty payments for the use of the patents or payments of the purchase price for the patents, depending upon whether or not Sunbeam exercised its option to purchase. It may have been necessary to treat them as royalties in prior years in order to permit the orderly collection of income taxes upon an annual basis. The petitioner did not know in those years whether or not the option would be exercised. But the inherent uncertainty of character which attached to the payments was removed in the taxable year when Sunbeam exercised its option to purchase the patents. Cf. Virginia Iron Coal & Coke Co., cited*754 in the majority opinion. It then became clear for the first time that the payments were payments of purchase price. The character of the payments made in 1935 did not have to be determined for income tax purposes prior to the date the option was exercised, and there is no reason why all of the payments made during that year should not be recognized for income tax purposes as payments of the purchase price, which, in fact, they finally turned out to be. Thus, the petitioner is not subject to any tax or penalty as a holding company.
*1315 Although the Commissioner here refuses to recognize these payments as a part of the purchase price of the assets, he has insisted, in the case of Sunbeam, that they were a part of the purchase price and not deductible by Sunbeam as royalties. He thus recognizes the dual character of the payments for his own double and inconsistent advantage.
I can not believe that Congress ever intended a personal holding company tax and penalty for failure to file a return to apply in a situation like that presented here and, therefore, the result reached by the majority seems particularly unfortunate.
ARUNDELL, VAN FOSSAN, MELLOTT, KERN, and OPPER*755 agree with this dissent.