*905 During the taxable year the petitioner received payments from certain patent licensees. The payments were designated "royalties" in the license agreements and were equivalent to a specified percentage of the net selling price of the patented article. The parties, in each instance, intended part of the payments as compensation for engineering services to be rendered by the petitioner to the licensees in accordance with agreements made at the time the license agreements were executed. Held, that a portion of the total amount received by the petitioner from the licensees during the taxable year was compensation for services rendered and not "royalties" within the meaning of section 353(a) of the Revenue Act of 1937 and to that extent the payments received from the licensees did not constitute personal holding company income in the hands of the petitioner.
*111 The respondent has determined a deficiency in personal holding company surtax for the year 1937 in the amount of $11,938.78. The single issue is whether more*906 than 80 percent of petitioner's gross income was personal holding company income within the meaning of section 351 of the Revenue Act of 1936, as amended by section 353(a) of the Revenue Act of 1937.
FINDINGS OF FACT.
The petitioner is a Michigan corporation, with its principal office in the city of Detroit. The return for the period here involved was filed with the collector of internal revenue for the district of Michigan.
Fred M. Guy and T. G. Murton, experienced automotive engineers, developed and patented an improved universal joint or flexible coupling. The joint is used to connect a motor unit with a driven unit in automobiles and trucks. The patents were transferred to a corporation, Guy & Murton, Inc., organized simultaneously with petitioner in 1928. The stock of Guy & Murton, Inc., was issued in equal shares to Fred M. Guy and T. G. Murton. Thereafter, under license agreements with Guy & Murton, Inc., the petitioner received exclusive rights to manufacture, sell, and sublicense the universal joint and any improvements thereon.
The stock of the petitioner was issued to 16 persons, all of whom were experienced engineers and selected as stockholders of the*907 petitioner *112 because their training would be valuable in the development of the universal joint. More than 50 percent of the petitioner's stock was owned by the individuals Guy and Murton. The stockholders agreed that Guy and Murton would be full time employees of the petitioner and that they were to receive a nominal salary for such services. The stockholders agreed to look to dividends for all other compensation for professional services rendered on behalf of the petitioner.
The petitioner licensed several companies to manufacture and sell the joint. Several rubber companies were licensed solely to manufacture a rubber block which is a part of the assembled joint. Each license agreement designated the territory in which the licensee might operate. The licensees agreed to pay the petitioner a fixed percentage of the selling price of the licensed article. The entire payment required under each written agreement was designated a "royalty" in the license. The names of the licensees, the percentage agreed upon as a "royalty", and the total payments made by each licensee under the agreements during 1937, were as follows:
| Licensees | Percentage | Total payments |
| Percent | ||
| U.S. Rubber Co | 5 | $134.07 |
| Silentbloc, Ltd | 10 | 1,848.93 |
| Morse Chain Co | 7 | 5,333.34 |
| Raybestos-Manhattan, Inc | 5 | 3,065.51 |
| Laycock Engineering Co. (Thomas W. Ward, Ltd.) | 10 | 22,415.38 |
| Firestone Rubber Co | 5 | 268.10 |
| Thompson Products, Inc | 1 5-7 | 13,869.72 |
| Total payments | 46,935.05 |
Each of the license agreements was subject to cancellation at the option of the licensee. The agreement with the Morse Chain Co. required the licensee to pay $250 to petitioner and give 90 days' notice before cancellation could be effected. All other agreements were subject to cancellation upon six months' notice without payment of any penalty.
At the time the license contracts were executed the parties orally agreed that petitioner would furnish to the licensees whatever engineering services were necessary in connection with the manufacture and sale of the joint. It was understood by all the parties that such services would be substantial because of the special engineering knowledge required to adapt the joint to varied uses. The parties were unable to reduce the agreement with regard to petitioner's services to writing because it was impossible to determine precisely how long or at what time petitioner's*909 services would be required. When the contracts were executed it was also understood by the *113 parties that petitioner was to be compensated for the services it would render to the licensees. The "royalties" provided for in the contracts were intended by the contracting parties to be, in part, payment for the right to manufacture and use the patented joint and, in part, payment for the services to be rendered by the petitioner. Because of competitive products it would not have been possible for the licensees to pay more than approximately 4 percent of net selling price for the use of the patented joint itself. The excess of the required payments over 4 percent of net selling price was intended to be the compensation for petitioner's advice and services.
During the year 1937 Murton devoted approximately 30 percent of his time on behalf of the petitioner to the giving of engineering advice and services to the licensees. The balance of his time was given to the administration of petitioner's internal affairs. During 1937 Guy devoted his entire time to the giving of advice and services to the licensees for the petitioner. The services which he rendered to the licensees*910 consisted of designing new applications of the joint and advising in, and supervising, the manufacture of the product. Some of this work was done at the petitioner's office in Detroit, but a large portion of it was done in the plants of the licensees. Guy worked nights, Sundays, and holidays. Sixty percent of his time was devoted to Thompson Products, Inc. The time occupied by his work for that firm was equivalent to 90 percent of the time of a full time employee. His services to Thompson Products, Inc., during the year 1937 had a reasonable value of $10,000. The company did not consider the joint itself of immediate value, since it had continually lost money on it but hoped to develop it profitably. For that reason it considered the services furnished by the petitioner to be of primary value under the license agreement. At least $6,000 of the $13,869.72 paid to the petitioner by Thompson Products, Inc., during 1937 was paid for services rendered in accordance with the agreement. The company itself considered that all of the money paid by it under the agreement in 1937 was consideration for services rendered because of the fact that the joint itself was of no value to it in*911 that year.
Guy devoted 20 percent of his time to the Laycock Engineering Co., performing services similar to those performed for Thompson Products, Inc. The services rendered to the Laycock Engineering Co. during 1937 by Guy on behalf of the petitioner had a reasonable value of $10,000 and that amount of the total payments made by Laycock Engineering Co. to the petitioner was consideration for services rendered.
Guy devoted the balance of his time primarily to the Morse Chain Co. Engineering services rendered to that company during 1937 on behalf of the petitioner had a reasonable value of one-half the total payments made by the company, or approximately $2,600, and the *114 company considered that one-half of the total amount paid by it was compensation for services rendered.
In addition to the amount of $46,935.05 received from the licensees the only other income of the petitioner during 1937 was the amount of $3,204.60 received as dividends and $1,040.43 received as interest on securities.
At least one-half of the aggregate amount received by the petitioner from the several licensees during 1937 was compensation for services rendered by the petitioner during*912 that year. Less than 80 percent of petitioner's gross income consisted of royalties during 1937 and petitioner was not a personal holding company during the taxable year.
OPINION.
SMITH: The single question is whether 80 percent or more of petitioner's gross income for the year 1937 consisted of royalties within the meaning of section 351 of the Revenue Act of 1936, as amended by section 353(a) of the Revenue Act of 1937. If such was the case the petitioner concedes that it was a personal holding company in that year. It is not disputed that $4,245.03 of petitioner's gross income was personal holding company income within the meaning of the statute. If more than $10,236.03 of the amounts received under the license agreements was compensation for services and not "royalties", the petitioner's contention must be sustained, since in that event more than 20 percent of the petitioner's gross income was not personal holding company income within the meaning of the statute.
The respondent contends that the amounts received under the license agreements were royalties in their entirety and that we can not determine that such amounts were in part consideration for services rendered. *913 The petitioner argues that it is not bound by the contractual designation of the payments as "royalties", nor by the fact that the payments were based on a percentage of net selling price, and that the evidence clearly shows that more than the required portion of such payments was compensation for services. In the alternative, the petitioner argues that if the payments were "royalties" they were "overriding royalties" and for that reason are not royalties within the meaning of the statute.
The evidence clearly provides a basis for the allocation of the aggregate amount received by petitioner from the licensees to compensation for services and to royalties. At the time the contracts were executed it was understood and agreed by the parties that substantial services were to be rendered by the petitioner and the payments provided for in the contracts were accordingly fixed at a much higher percentage of net selling price than would have been the case had the payments been for the use and manufacture of the patented *115 joint alone. The parties found it impossible to draft a contractual provision which would clearly outline the respective rights and duties with regard to*914 engineering services. For that reason alone no express provision for such services was made in the agreements. The licensees were protected in their right to the services of the petitioner by the fact that the agreements were subject to cancellation at their option and by the further fact that since the payments were based upon percentages of net selling price it was to the petitioner's self-interest to furnish the services which might enlarge the market for the product. The evidence overwhelmingly shows that more than one-half of the total payments made under the license agreements during 1937 was compensation for the services of the petitioner as distinguished from compensation for the use and manufacture of the universal joint. Thus, the petitioner must prevail unless we are required as a matter of law to treat the payments as royalties in their entirety.
The designation of the payments as "royalties" in the agreements is obviously not conclusive. Such a label might be evidence that the payments were royalties if other facts did not show that they were not royalties as intended by the statute. *915 .
In , the taxpayer received payments under an agreement licensing a patented process. The license agreement termed the payments "royalties." The Board held that in fact a part of the "royalties" was compensation for services rendered by the licensor to the licensee in accordance with a provision of the agreement which was as follows:
* * * "The licensor agrees to instruct representatives of licensee, first to be designated in writing by the licensee, in the details of the operation of the 'the patent' and to give such supervision to the manufacturing operations of the licensee, of its various products, as in his opinion may be necessary and that shall and will not conflict with his other activities including absences in Europe and/or from San Francisco and/or the State of California."
This agreement by the taxpayer in the Dolenz case did not bind him to furnish the services, and amounts to no more than an indication on the face of the contract that such services might be rendered if the taxpayer considered them necessary. In the instant case there is nothing on the face*916 of the contract to indicate the agreement between the parties with regard to petitioner's services. The remaining question in the instant case is therefore whether we may look outside the contract itself to discover the true nature of the payments in question.
It is manifest that we may do so. It is well to note that the parol evidence rule is not and can not be invoked in this case. . It is necessary *116 for us to define the word "royalties" in order that we may ascertain whether the petitioner used that word in a statutory sense. We have defined a royalty as a payment or interest reserved by an owner in return for permission to use the property loaned and usually payable in proportion to use. ; Upon examination of the facts in this case we have found that the payments made to the petitioner were only partially intended as compensation for the use of the patented joint. To the extent that the payments were compensation for services rendered and not compensation for the use and manufacture of the joint, *917 they were not royalties as we have defined them and they were not royalties within the meaning of the statute.
; , and , are cases relied upon by the respondent. They are distinguishable upon their facts. The questions involved in those cases were similar to the question in the instant case. However, it is apparent that in each of those cases the taxpayer failed to present evidence upon which the requested allocation of the payments in question could be made. In the instant case the petitioner has clearly proved that part of the payments made by each licensee was made in consideration of services rendered. The cited cases are not in point.
It is not necessary to consider the petitioner's alternative contention.
Decision will be entered under Rule 50.
Footnotes
1. Sliding scale of percentages based upon volume of sales. In the event that Thompson Products, Inc., obtained the business of certain large automobile companies the royalty was subject to agreement, or if no agreement could be made a 4 percent royalty was payable. ↩