*2997 1. In 1906 the petitioner acquired all the assets of another corporation and as part payment therefor assumed the vendor corporation's indebtedness other than its bonded debt. In the taxable year petitioner acquired at less than par and incinerated the remaining outstanding bonds of the vendor corporation. Held, that it derived no taxable income from such transaction.
2. The tax liability for a previous year as determined by the Board in an earlier proceeding under the Revenue Act of 1924 is, until set aside by a proceeding in court, the correct amount to be used in determining invested capital for the year in question.
*328 The Commissioner determined a deficiency of $21,647.51 income and profits taxes for 1921. The petitioner contends:
1. That it realized no income from the purchase of $91,000 of outstanding bonds for $70,975.76.
2. That its invested capital should include:
(a) $25,000 paid in 1915 for certain rights in inventions, patent applications and patents;
(b) $500 attorneys' fees in connection*2998 therewith;
(c) $15,000 paid for royalties under a certain license agreement;
*329 (d) $198,716.37 experimental and development costs incurred in 1912 and prior years incident to changing its product from seats made with cast iron frames to seats made with steel frames.
3. That the reduction of its invested capital for 1921 by reason of taxes for 1920 should not exceed $196,407.99 as determined by the Board in a prior decision () instead of $207,708.50 used by respondent.
The findings of fact are as requested by petitioner. The facts which were found by the Board in the earlier proceeding and introduced in evidence in this proceeding are embodied verbatim in the findings.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the State of New Jersey, in the year 1906, for the purpose of taking over the business and properties of the American School Furniture Co., also a New Jersey corporation.
On April 23, 1906, the American School Furniture Co. made the following offer to the petitioner:
To the board of directors of American Seating Company:
The undersigned, American School Furniture*2999 Company, hereby offers to convey, transfer, and set over to your Company its entire property, real and personal, good will and business, including its real estate, bills and accounts receivable, cash on hand, contracts and personal property of all kinds, subject, however, to its mortgage indebtedness and also to deliver $1,021,000 par value of its said First Mortgage Bonds, all for the following consideration:
(a) $1,021,000 of the Preferred Capital Stock of your Company;
(b) $1,999,000 par value of the Common Capital Stock;
(c) The agreement by your company to perform all this company's outstanding contracts and the assumption of the aforesaid indebtedness other than bonded debt;
(d) An amount in cash equal to the interest accrued on the said $1,021,000 of bonds from October 1, 1905, to the 1st day of April, 1906.
Dated, New York, April 23rd, 1906.
AMERICAN SCHOOL FURNITURE COMPANY,
By THOS. M. BOYD, President.
This offer was accepted and by its acceptance petitioner acquired $1,021,000 par value of the $1,161,000 of bonds secured by the mortgage on its properties in the amount of $1,161,000, leaving a balance of $140,000 par value of bonds outstanding in the*3000 hands of the public. In 1907 petitioner acquired $49,000 par value of the outstanding American School Furniture Co. bonds by the issuance of preferred stock, leaving bonds outstanding having a par value of $91,000.
On October 21, 1921, the directors of the American Seating Co. adopted the following resolutions:
WHEREAS, the AMERICAN SEATING COMPANY at the time of acquiring the property of the AMERICAN SCHOOL FURNITURE COMPANY also acquired ownership of ten hundred twenty-one (1021) of the first mortgage bonds of said AMERICAN SCHOOL FURNITURE COMPANY, the total authorized issue of said bonds outstanding *330 being eleven hundred and sixty-one (1161), all of which bonds mature in 1929; and
WHEREAS, the American Seating Company does now own ten hundred seventy (1070) of said outstanding eleven hundred sixty-one (1161) bonds;
NOW, THEREFORE, IT IS HEREBY RESOLVED, That the President of the American Seating Company is hereby authorized to purchase the remaining outstanding bonds; and
BE IT FURTHER RESOLVED, That the President of the American Seating Company take all the necessary steps, through the Trustees, in having all of the said eleven hundred sixty-one (1161) bonds*3001 destroyed and the mortgage satisfied as of record.
In accordance with the authorization of the directors the $91,000 par value of the American School Furniture Co. bonds were purchased in 1921 at a cost of $70,975.76. The mortgage on petitioner's properties for $1,161,000 was then satisfied and the bonds issued thereunder were incinerated.
Since the time of its organization in 1906 petitioner has been continuously engaged in the business of manufacturing and selling desks, chairs and seats for schools, churches, theatres and other places of public assembly.
Prior to 1911 the framework of the desks and seats was made of cast iron manufactured at the taxpayer's foundry. As early as 1909 it was found that the cast-iron frame did not stand up under the hard usage of the school; that it was subject to breakage both in use and in transit, resulting in considerable economic loss.
In 1909 it was decided to substitute a steel frame for the cast-iron one then in use, and the taxpayer's engineers were put to work on the problem and continued on the experimental and development work during 1910, 1911, and 1912. The change from the use of the cast-iron frame, which was comparatively*3002 simple to manufacture, to the steel frame was a radical departure from the methods of production then employed. It required not only additional buildings, machinery, and equipment, new dies, jigs, tools, and patents, but a complete change in the specifications of the remaining wooden parts, as well as a period of experiment and development during which the imperfections in the plans and specifications must be discovered and corrected and the machinery of operations by which quantity production was to be reached adjusted to meet such changes. This petitioner was the pioneer in the manufacture of the steel standard desk and therefore could not benefit by the experience of others.
In 1910 new buildings were constructed and machinery and equipment acquired and installed, following which the manufacture of the steel standard desk was started. There was some little production in 1910. Real production began in 1911. The period of transition from the cast-iron frame to the steel frame continued through 1911 and 1912. During this entire transition period the *331 petitioner kept an accurate and detailed record of the cost of changing from the cast iron to the steel frame, and*3003 such cost so recorded upon the taxpayer's books of account on December 31, 1912, amounted to the aggregate of $398,934.39. All of this aggregate was regularly charged on the books of the taxpayer as capital expenditures and none of it was ever charged to operating or other expenses.
When the petitioner entered upon and began the development of the use of steel frames, it opened on its books of account a capital expenditure account under the designation of "steel construction." Into this account were charged many items of cost of material, labor, and superintendence. The transition from cast iron to steel frame resulted in many imperfections in plans, specifications, tools, dies, jigs, etc., with the natural result that a large part of the production of parts, and sometimes of completed desks and seats, was found to be not marketable and was junked, and this, of course, required the junking of all jigs, dies, etc., the making of new ones, and the production of new parts entering into the construction of a completed and assembled marketable desk. Complete and accurate records of the cost of producing the steel standards were regularly kept from the beginning of the venture until*3004 the close of the year 1912. The steel construction account appearing on the company's ledger for the years 1911 and 1912 is summarized as follows:
| Dr. | Cr. | |
| 1911 - January 1 balance brought forward | $96,446.87 | |
| 33 items aggregating | 37,707.08 | $600.00 |
| Oct. 26 St. Louis contracting acct | 33,239.77 | |
| Dec. 30 Steel operating loss | 55,296.55 | |
| Debit balance | 222,590.27 | |
| 1912 - January 1 balance brought forward | 222,590.27 | |
| 40 items, aggregating | 66,164.09 | 118.00 |
| Dec. 31 operating loss | 110,180.05 | |
| Debit balance | 398,934.39 |
In the foregoing items of operating loss for the years 1911 and 1912, summarized from the petitioner's ledgers, are exhibited as follows:
| Cr. | Dr. | |
| Steel | $58,215.54 | |
| Finishing material | 2,286.75 | |
| Direct supplies | 440.47 | |
| Non. Prod. supplies: | ||
| Dept | $5,693.72 | |
| H.L. & P | 1,363.60 | |
| General | 650.53 | 7,707.86 |
| Packing material | 433.85 | |
| Productive labor | 45,511.69 | |
| Non. Prod. labor: | ||
| Dept | 19,323.59 | |
| H.L. & P | 103.22 | |
| General | 2,496.17 | 21,922.98 |
| Fixed charges | $2,051.24 | |
| Iron | 4,790.95 | |
| Packing labor | 2,230.70 | |
| Cutting crating | 114.48 | |
| 145,706.51 | ||
| Shipments-credits | $47,620.57 | |
| Improvements-credits | 3,773.41 | |
| Inventory 12/30/11 | 54,955.96 | |
| 106,349.74 [sic] | ||
| Inventory 12/31/10 | 15,939.78 | |
| 90,409.96 | ||
| Loss | 55,296.55 | |
| Inventory Jan. 1, 1912 | 54,955.96 | |
| Productive labor | 92,840.92 | |
| Pro rate (factory overhead, such as supervision, foremen, and all labor in steel plant except productive labor) | 82,148.38 | |
| Steel consumed | 114,198.65 | |
| Iron room prod. labor Japanning | 7,405.82 | |
| Iron room pro rate on above | 5,549.00 | |
| Japan material | 10,346.24 | |
| Packing steel a/5612 and pro rate | 9,135.09 | |
| Packing material and cut crating labor | 2,960.09 | |
| 379,540.15 | ||
| School shipments stock and samples | $169,058.25 | |
| Church shipments | 252.14 | |
| Opera shipments | 6,038.49 | |
| Miscellaneous shipments | 706.96 | |
| Transfers iron scrap (transferred to another factory) | 15,884.68 | |
| Improvements and pro rate | 4,240.38 | |
| Inventory Jan. 1, 1913 | 73,179.20 | |
| 269,360.10 | ||
| Difference, loss | 110,180.05 |
*3005 *332 During the years 1911 and 1912 studies were made to determine the cost of producing each unit. From these studies it was determined that the cost of labor, materials, and overhead entering into the production of the salable articles was a certain amount per article. The taxpayer then determined that $55,296.55 of the amount expended during the year in the manufacture of the steel standards was properly chargeable to capital as experimental and development expense. This amount was arrived at in the following manner: To the opening inventory was added productive labor, factory overhead, cost of steel consumed, cost of painting and packing. The total so obtained represented the total cost of constructing the steel standards, sold during the year, junked during the year, and on hand at the end of the year. This total was then credited with (1) the shipments made, valued at a figure which the taxpayer had ascertained from its time studies of cost of production, to be the normal *333 cost of producing a unit; that is, the cost of the material used in producing a unit, the cost of the productive labor necessary for its manufacture as well as the factory overhead*3006 cost attributable thereto, (2) transfers of materials including junk and scrap, and (3) the inventory at the close of the year valued in the same manner as the shipments out as in (1) above. The costs for 1911 so obtained exceeded the credits by $55,296.55, which, in the opinion of the taxpayer, represented the amount expended in the manufacture of steel standards properly attributable to experimental and development expense. This amount reflected the cost of material, labor, factory overhead, tools, jigs, dies, etc., used in manufacturing the units that were junked or scrapped during the year while in the process of construction.
This $55,296.55 was not charged to expense on the books of the taxpayer but was charged to its capital account "Plant and Properties." Furthermore, it was not deducted on the Federal excise-tax return filed for the year 1911, showing a net income of $79,207.83 and upon which the tax due was paid.
The amount charged by the taxpayer to capital account for 1912 for experimental and development expense, determined in the same manner as the $55,296.55 for 1911, was $110,180.05. Likewise, this amount was neither deducted on the taxpayer's books as an expense*3007 nor in the Federal income-tax return filed for that year showing a net income of $51,397.49 upon which the tax due was paid.
The first contract which the taxpayer procured for the steel standard desk was with the board of education of the City of St. Louis, Mo. The first production of the steel standard desk was under this contract. Before the order was completed certain weaknesses evidenced themselves, but under the contract delivery was guaranteed by a certain date. The desks were accordingly shipped, delivered and installed. Later on, and in 1912, it became necessary to manufacture new desks to replace the defective ones theretofore installed. The defective ones were junked. The cost in 1912 of replacing the desks junked was $33,239.77, which the taxpayer considered as representing the experimental and development expenses properly attributable to this particular contract. This $33,239.77 was therefore charged to capital by the taxpayer as experimental and development expense and not charged to expense on the books or in the income-tax returns filed for that year, which, as previously stated, showed a net income of $51,397.49 upon which tax was paid.
After having deducted*3008 from the total cost of manufacturing the steel standards sold, junked, and on hand at the end of the years 1911 and 1912, the $55,296.55 and $110,180.05, respectively, for experimental and development expenses, the percentage of factory *334 costs to school sales, that is, the cost of the complete marketable desk, including the steel standard as well as other parts, was a greater percentage of the sales price than in the years prior and subsequent to the experimental period 1910 to 1913, inclusive, as is shown by the following tabulation:
| Year | School sales | Factory costs | Per cent |
| 1908 | $298,160.79 | $182,536.03 | 61.1 |
| 1909 | 294,608.13 | 178,675.33 | 60.7 |
| 1910 | 247,176.02 | 157,859.64 | 63.8 |
| 1911 | 298,684.96 | 187,932.56 | 62.9 |
| 1912 | 629,672.02 | 430,346.70 | 68.3 |
| 1913 | 769,655.78 | 549,333.63 | 71.4 |
| 1914 | 758,353.42 | 472,516.36 | 62.3 |
The $398,934.39 charged to the taxpayer's capital account "Plant and Properties," on account of experimental and development costs during the period in which the steel standard desk was being developed and perfected, remained in the "Plant and Property" account until 1914, when, upon the recommendation of accountants engaged*3009 in auditing the taxpayer's books, it was eliminated from that account and surplus account was charged with a like amount. This was a surplus adjustment, not an income adjustment, and the income for 1914, as shown on the books for that year, was not affected in any manner by the adjustment, nor did the income shown by the Federal income-tax returns filed for that year reflect the adjustment.
Later on, and in 1919, the entries made in 1914 charging off against surplus the $398,934.39 of experimental and development costs were reversed upon the recommendation of accountants and the amount was restored to the "Plant and Property" account as well as to surplus, where it remains today.
The petitioner has continued to manufacture school desks and seats with steel frames up to the present time.
On or about the third day of March, 1911, the petitioner entered into a so-called agreement of license with the Welded Steel Products Co., a Delaware corporation, which recited that the said Welded Steel Products Co. is the "owner of inventions for certain new and useful improvements for which patents have not yet been issued or applied for but for which it is intended to make application*3010 for letters patent as soon as possible"; and further, that "such inventions comprise a method of steel construction particularly applicable in and adapted to the manufacture of seating furnishings and fittings for schools, educational institutions, places of amusement or congregation, opera houses, theatres, temple halls, churches or places of worship," and further, the said agreement in the usual and proper language granted to the petitioner and its assigns full and exclusive *335 license and authority to manufacture and sell all kinds of seatings, furnishings, and fittings, for schools, etc., embodying or containing, or made in accordance with, the methods of such inventions, and in consideration of such grant of license the petitioner undertook to pay to the licensor certain specifically described royalties upon all articles manufactured and sold under such inventions.
Thereafter, and on or about August 3, 1915, the petitioner and the Welded Steel Products Co. entered into another written agreement which contained, among other things, recitals as follows:
WHEREAS, under date of the 3d day of March, A.D., 191 , the parties hereto entered into a certain AGREEMENT OF LICENSE*3011 with reference to certain inventions for certain new and useful improvements, for which patents at said date of March 3, 1911, had not been issued or applied for, but for which patents upon a part of said inventions have subsequent to said March 3d, 1911 been applied for,
* * *
WHEREAS, the parties to said AGREEMENT OF LICENSE have, subsequent to the execution and delivery thereof, been operating, manufacturing, selling and governed thereunder by said AGREEMENT OF LICENSE, and certain sums of royalty have been paid by the SEATING COMPANY to the PRODUCTS COMPANY under said AGREEMENT OF LICENSE, * * *
NOW THEREFORE IT IS NOW AND HEREBY AGREED between the parties as follows:
(1): The parties hereto agree and certify that they have had between them an accounting under said AGREEMENT OF LICENSE of March 3d, 1911, and have struck a balance in the matter thereof and found nothing due from either to the other, and each party, for a mutual consideration received, releases, discharges and acquits the other of any claim or demand of any kind or nature whatsoever growing out of said AGREEMENT OF LICENSE of March 3d, 1911, or any acts or things done thereunder or with reference to the matters*3012 and things therein provided for.
* * *
(3): For and in consideration of the sum of TWENTY-FIVE THOUSAND DOLLARS ($25,000) in hand paid by the SEATING COMPANY to the PRODUCTS COMPANY (receipt whereof is now and hereby acknowledged) and of the covenants and agreements herein contained, the PRODUCTS COMPANY hereby sells, assigns, transfers and sets over to the SEATING COMPANY, all its rights, title and interest in and to said inventions and applications for patents thereon, or patents, if issued. It is further understood and agreed that the PRODUCTS COMPANY in no way guarantees the validity of any patent or inventor's rights in the matter of said inventions.
On or about the said 3d day of August, 1915, the petitioner, pursuant to the agreement last above referred to, purchased the patents and inventions in said agreement described and thereupon paid to the Welded Steel Products Co. the sum of $15,000 in settlement and adjustment of all royalties due under the contract of March 3, 1911, and the further sum of $25,000, the purchase price of said inventions and patents as agreed to in the agreement of August 3, 1915; and at or about the same time the petitioner paid to its legal*3013 counsel *336 a fee of $500 for legal services in connection with the making of said contract and counsel and advice relating thereto, and on December 3, 1915, it caused to be made journal vouchers as follows:
| Debit | Credit | ||
| 9540 | 73 Plant and property (exp. and del.) | $500.00 | |
| 34 Sheridan Wilkerson & Scott | $500.00 | ||
| Legal advice in connection with purchase from the Welded Steel Products Co. | |||
| 9541 | 73 Plant and Property (exp. and del.) | 40,000.00 | |
| 34 Welded Steel Products Co | 40,000.00 | ||
| In full for all royalties under contract dated March 3, 1911 | 15,000.00 | ||
| In full for all rights, title and interest in inventions and applications for patents thereon, or patents if issued, owned, and to be owned by the Welded Steel Products Co. as per contract dated Aug. 3, 1915 | 25,000,00 | ||
| 40,000.00 |
The entire amount of $40,500 so paid was considered by the petitioner as its cost in acquiring the patent and was then charged to its capital account, "Plant and Properties," and not to expense, and the whole amount of said sum has at all times remained in the petitioner's capital account and it so remains at this time.
In auditing the petitioners' *3014 income and profits-tax return for the year 1920, the Commissioner eliminated from invested capital the items of $40,500 charged as cost of patents and inventions. He also eliminated the item of development expense relating to the so-called St. Louis contract, $33,239.77, and the so-called operating loss items of $55,296.55 for the year 1911, and $110,180.05 for the year 1912, aggregating $198,712.37.
In determining petitioner's invested capital for the year 1921 respondent deducted $207,708.50 for Federal income and profits taxes for the year 1920. Petitioner's Federal income and profits-tax liability for said year as determined by this Board is $196,407.99.
OPINION.
SMITH: 1. The first point presented is whether the petitioner derived income of $20,024.24 in 1921 from the purchase of $91,000 par value of the bonds of the American School Furniture Co., which it acquired and incinerated during the year. The petitioner acquired the assets of this company in 1906. It did not assume the bonded indebtedness of the vendor company. The assets acquired were, however, subject to the mortgage given by the American School Furniture Co. It is the respondent's contention that by*3015 reason of the purchase of these bonds and the incineration of them it acquired taxable income in the amount stated.
*337 The purchase of these bonds by the petitioner was a capital transaction. In , we stated:
The liquidation of a liability of known or unknown amount assumed by a corporation as a part consideration for the purchase of assets is not an ordinary and necessary expense of doing business. It is a capital transaction. * * *
A fortiori the paying off of indebtedness secured by a lien on a taxpayer's property is a capital transaction. The payment represents a part of the cost of the assets. The petitioner derived no taxable income from the purchase of the bonds in 1921.
Even if it be considered that the bonds acquired were an obligation of the petitioner by reason of the fact that they were secured by a lien upon petitioner's assets, we are still of the opinion that the petitioner derived no income from the acquisition and incineration of the bonds. *3016 ; ; ; ; .
2. In the instant proceeding the petitioner rested its case entirely upon the facts found by the Board in the earlier decision. Pursuing the course approved by the Board in , and , the petitioner introduced in evidence the findings of fact made by the Board in the prior case resting upon the prima facie case made thereby. The respondent introduced no controverting evidence but objected to the offer, insisting that the Board's findings were incompetent and further that they should be accompanied by the transcript of evidence upon which such findings were based.
In the prior proceeding, reported in , we held that amounts paid for acquiring title to certain inventions represented by applications for patents and expenses incident thereto*3017 are capital expenditures and that they constituted elements of invested capital; also that the cost of developing and perfecting the manufacture of a newly designed product is a capital expenditure, and where such cost was so treated in the year in which it was incurred and was later charged off to surplus the taxpayer was entitled to reinstate the amount in surplus and include the same in invested capital. The respondent now urges that even assuming that the amounts were properly classified as capital expenditures in 1911, 1912, and 1915, as the Board held, it does not follow that they were still within invested capital in 1921. He urges that since the amount is sought by the petitioner to be included in invested capital by way of earned surplus, it is necessary for the petitioner to show that the earned surplus was in fact there in the taxable year.
We have carefully considered the findings of fact upon which the prior decision was based and we note that the situation with respect *338 to 1921 is not different from what it was with respect to 1920. The ruling made by the Board in the prior decision is controlling in the instant proceeding. Invested capital should be*3018 determined accordingly.
3. Upon the third point we think that the petitioner is correct. The Board, after hearing, decided that the correct tax liability of the petitioner for 1920 was $196,407.99. This is a final determination until judicially held otherwise. The respondent has contested this determination by instituting suit in the District Court. The case, however, has not yet come on for trial. In this stage of the proceeding we find no reason to act upon the assumption that the 1920 tax liability found by the Board must give way to that insisted upon by the Commissioner. . The reduction for 1920 taxes should be in the amount of $196,407.99.
Reviewed by the Board.
Judgment will be entered under Rule 50.
STERNHAGEN and MURDOCK dissent from the decision on the first and second issues.