*271 Decision will be entered under Rule 50.
1. Income -- Abnormal. -- Whether profit realized by petitioner from sale of equipment manufactured to order of one customer but sold to another customer was "abnormal income" within the meaning of
Id. -- Capital Gain. -- Held, further, that the gain resulted from a sale of capital assets held for more than 6 months,
2. Equity Invested Capital. -- Claimed increases in equity invested capital held properly disallowed except for sum paid in settlement of second mortgage judgment against plant acquired by predecessor.
Id. -- Operating Deficit. -- Held, that deficit of merged corporation properly disallowed as not meeting requirements of
3. Deduction -- Business Expense. -- Royalty payments made in taxable years held to be deductible as ordinary and necessary expenses in carrying on business.
*451 *413 FINDINGS OF FACT AND OPINION.
This case involves the following tax deficiencies asserted*272 against petitioner:
| Declared value | Excess profits | |||
| Year | Income tax | excess-profits | tax | Total |
| tax | ||||
| 1943 | 0 | $ 18,667.57 | $ 123,250.05 | $ 141,917.62 |
| 1944 | $ 2,778.56 | 8,870.67 | 73,607.28 | 85,256.51 |
| 2,778.56 | 27,538.24 | 196,857.33 | 227,174.13 |
Several issues have been conceded and will be reflected in Rule 50 computation. The following issues remain for disposition:
(1) Whether the amount of $ 8,582.92 received by petitioner in 1943 as profit on the sale of certain equipment was (a) ordinary income as treated by respondent, or, as contended by petitioner, *273 either (b) abnormal income within
(2) Whether respondent, for the calendar years 1943 and 1944, properly determined petitioner's excess profits tax credit; and
(3) Whether respondent properly disallowed as deductions from gross income the amounts of $ 120,000 and $ 95,250 for the calendar *414 years 1943 and 1944, respectively, claimed to have been paid by petitioner as royalties for the use of patents in those years.
For clarity, general findings of fact applicable to all issues first will be made, then findings and decision on each issue separately.
GENERAL FINDINGS OF FACT.
The facts stipulated are so found and the stipulation by reference is made part of our findings.
The income and excess profits tax returns for the years here involved were filed with the collector of internal revenue for the tenth district of Ohio. On June 13, 1949, petitioner filed with the collector of internal revenue at Toledo, Ohio, its claim for refund of income tax paid by it for the year 1943 in the amount of $ 7,521.28.
Petitioner is an Ohio corporation with its principal office at Findlay, Ohio. It*274 was incorporated in 1927 under the name of Differential Car Manufacturing Corporation and is the continuing corporation which resulted from a merger on December 30, 1937, of The Differential Steel Car Company with petitioner which at that time changed its name to Differential Steel Car Company.
During the taxable years and from the time of incorporation petitioner and its predecessor were engaged in the manufacture and sale of specially designed haulage equipment for mines, railroads, quarries, etc.*452
Findings of Fact -- Issue No. 1.
Almost all of petitioner's products were manufactured and sold under special orders, that is, "tailor-made" for particular customers.
In 1937 a customer contracted with petitioner for the manufacture of three haulage units. Petitioner, due to delays in securing equipment was unable to make the specified delivery date and the customer refused to accept the units. The units were nevertheless completed in October 1937 at a cost of a great deal more than originally estimated and remained on tracks at petitioner's plant.
Meanwhile there was a rising market for such equipment and petitioner continued negotiations with the customer hoping satisfactorily *275 to consummate the sale. These negotiations fell through finally in 1941.
Petitioner's operations were such that a switch engine was needed to transfer cars under construction from one bay of the plant to another as the manufacturing process proceeded. For about six months in 1942 and four months in 1943 one of the unsold three units was used as a switch engine to supplement the engine ordinarily used.
In 1943 this unit was sold at a profit of $ 8,582.92. The unit was of the same general class of equipment normally manufactured and sold by petitioner in the regular course of business.
*415 This was the only time a customer ever had refused delivery of equipment contracted for with petitioner.
In its excess profits tax return for 1943, on schedule A, petitioner claimed abnormal income as a deduction in the amount of $ 8,582.92. This the Commissioner disallowed with the explanation in the deficiency notice that it had not been substantiated.
Opinion -- Issue No. 1.
Petitioner contends that the entire profit of $ 8,582.92 realized from the sale of equipment manufactured in 1937 for sale and delivery to a particular customer in that year but which was sold to someone else in*276 1943, constituted "abnormal income" within subsection (a) (1) of
The basis for petitioner's argument is the "unique" set of circumstances, so far as petitioner's business is concerned, which gave rise to the profit in 1943. It claims that in the normal course of its business the profit would have been realized in 1937 and so was properly attributable to that year instead of 1943.
We need not decide whether the item was properly classifiable*277 as abnormal within the meaning of
We turn now to petitioner's alternative contention, that the $ 8,582.92 profit was derived from a sale of "property used in the trade or business" within the meaning of
Findings of Fact -- Issue No. 2.
In 1927 petitioner's predecessor acquired through purchase at a mortgage foreclosure sale, for $ 18,200, certain property known as its North Plant, such assets being taken upon the books of petitioner's predecessor at approximately that figure. In the same year the predecessor corporation paid to the United States the sum of $ 20,000 in settlement of a judgment obtained by the Government in the same foreclosure proceedings on a second mortgage which it held on the property. This $ 20,000 was charged off to profit and loss and deducted by petitioner's predecessor on its 1927 income tax return and such amount has never since been restored on the books.
At the time the plant was acquired it contained some machinery and equipment placed there by the prior occupant. Petitioner's predecessor took over this machinery and equipment with the plant and put it to use in the business.
On December 30, 1937, at the time of the merger of The Differential Steel Car Company with petitioner, The Differential*280 Steel Car Company's books of account showed an operating deficit in the amount of $ 50,084.68.
In petitioner's corporation excess profits tax returns for the calendar years 1943 and 1944 there were included in schedule "C" an amount of $ 168,202.19 as property paid in for stock, or as paid in surplus, or as a contribution to capital, and the amount of $ 50,084.68 as deficit *417 in earnings and profits of another corporation under
In the statement accompanying the deficiency notice dated April 1, 1949, sent by the Commissioner to petitioner, appears the following:
In computing invested capital as a basis for the excess profits credit, money and property paid in for stock, or as a contribution to capital, has been determined, as follows:
| Jan. 10, 1927 -- Assets acquired from The Differential Steek Car | |
| Co. for stock | $ 101,434.23 |
| Stock issued for accounts payable | 1,965.77 |
| Stock issued for cash | 77,550.00 |
| Dec. 28, 1937 -- Assets acquired from The Differential Steel Car | |
| Company as contribution to capital | 1,615.32 |
| Jan. 1, 1938-Jan. 1, 1941: Cash paid in on stock subscriptions | 90,475.00 |
| Total | 273,040.32 |
*281 Your contention that this total amount should be increased by $ 168,202.19, relating to property acquired by a predecessor from The Chicago Steel Wheel Company, has been denied for lack of substantiation. Your further contention that accumulated earnings and profits, includible in invested capital, should be increased by $ 50,084.68 representing a deficit in earnings and profits of a predecessor corporation, has been denied because of the inapplicability of
Opinion -- Issue No. 2.
Petitioner claims that it is entitled to include the property and equipment of its North Plant in its equity invested capital for excess profits credit purposes at a figure substantially in excess of the figure at which the plant had been carried on petitioner's books, that figure being $ 16,556, representing the depreciated balance of the $ 18,200 paid at the foreclosure sale for the plant.
Petitioner argues that the proper figure at which it should be allowed to include the plant is $ 105,000. In substantiation of this figure it is pointed out that the evidence shows that the plant had cost petitioner at least $ 38,200 in cash (the*282 amount paid at the foreclosure sale plus the $ 20,000 paid the Government on its second mortgage judgment). Furthermore, petitioner's president testified that in his opinion the fair market value of the plant at the time of its acquisition was $ 105,000. He also testified that in 1920 the plant had been sold for $ 100,000, this figure being made up as follows:
| $ 5,000 | cash |
| 27,500 | notes of the purchaser |
| 18,000 | assumption by purchaser of first mortgage |
| 24,500 | assumption by purchaser of second mortgage |
| 25,000 | preferred stock of purchaser |
| $ 100,000 |
*418 Reluctant as we are to decide issues on the basis of lack of proof, from this evidence we are able to conclude only that petitioner is entitled to have allowed, in addition to what the Commissioner has already allowed, the $ 20,000 paid in settlement of the second mortgage judgment against the plant. It does not appear that this amount was included by the Commissioner, but it seems to be a proper cost item in connection with the acquisition of the plant and should be included in petitioner's equity invested capital.
The evidence adduced to support the $ 105,000 figure is unconvincing. It consists merely of the *283 opinion of petitioner's president without substantiating facts. The sale of the property a few years before for a claimed $ 100,000, upon analysis, does not help petitioner. Only $ 5,000 in cash was involved. The rest of the $ 100,000 figure which consisted of notes, the assumption of mortgages and preferred stock of the purchasing corporation mean little. There is not a bit of evidence as to the financial condition of the purchaser or the value, if any, of its preferred stock. That the purchase had little substance may be gathered from the fact that within a few years the purchaser had defaulted on its mortgages and that petitioner acquired the plant at foreclosure proceedings for a bid price of $ 18,200. This record does not justify a finding that petitioner is entitled to include any amount with reference to its North Plant in equity invested capital other than as allowed by the Commissioner plus the $ 20,000 referred to above.
We turn now to petitioner's claim with respect to the machinery and equipment contained in the North Plant at the time of its acquisition. This machinery and equipment was not covered by the mortgages foreclosed in 1927. Nevertheless, petitioner took*284 possession of and used the machinery and equipment in its business apparently without any adverse claim being asserted to it. In petitioner's view this amounted to property contributed to petitioner's capital within
It is difficult to gather from this record why either the corporation which had previously occupied the North Plant or its preferred stockholders should want to contribute capital to petitioner. Even though we assume that the machinery and equipment constituted a contribution to capital within the ambit of
The next phase of the equity invested capital issue to be dealt with is whether petitioner is entitled to include under the provisions of
*286 Petitioner in contending that it is entitled to the benefits of
Respondent, on this question, argues that the record is devoid of evidence which would show that the formation of petitioner was such as to entitle it to the benefits of
A careful consideration of the whole record compels us to agree with respondent.
*420 As pointed out in
On this record, we cannot find proof that the section's requirements were met. In the first place,
Findings of Fact -- Issue No. 3.
Petitioner and its predecessor manufactured and sold its products under licenses granted by Henry Fort Flowers, the inventor of the patented features utilized in such*289 products. Flowers also owned the major portion of petitioner's stock and had owned it for a long period of years.
The minute book for the year 1922 of one of petitioner's predecessors reveals that it was "Resolved that the company shall buy the *421 right to manufacture Differential cars for the year 1922, from the owners of the patents at the rate of $ 1,000 per car."
Other than the above resolution, there was nothing further in writing between Flowers and the petitioner relative to the use of patents until 1938.
Throughout its existence, with the exception of 1938 when a "Special royalty" was paid, petitioner, during years when royalties were paid, has paid the same amount per unit in royalties regardless of the amount of its profits.
In 1943 a memorandum of agreement was signed by petitioner and Flowers superseding a similar license agreement executed between the parties in 1938, giving petitioner a nonexclusive right to use the patents. This agreement embodied the practice of prior years whereby the amount per unit remained constant and was paid if petitioner's net profits were such as to make payment possible. The agreement covered 23 patents issued during the years 1926-1937*290 and contained the following provisions:
As a condition for the rights herein granted, Licensor hereby reserves for himself and Licensee hereby agrees to pay to Licensor the following royalty on Dumping Vehicles manufactured by it:
$ 2,000.00 per Electric Locomotive, including Larry Cars
$ 1,000.00 per Railroad Type Dump Car
$ 200.00 per Mine Car, 100 cu. ft. capacity and larger
$ 150.00 per Mine Car less than 100 cu. ft. capacity
5% selling price on all Repair Parts and Vehicles for rental use.
$ 25.00 per ton of capacity on all vehicles not included above.
It is also understood and agreed that if, just prior to the close of any calendar year covered by this agreement, it appears that payment of royalty in accordance with the above schedule shall cause the Licensee to operate without profit for that particular year, the above schedule shall, before the end of the calendar year, be subject to compromise and revision to avoid any undue hardship on the Licensee for that particular year. Any compromise agreement shall affect only the payments for the calendar year in which the compromise is made and to have no effect on the above royalty schedule for the prior or succeeding years*291 covered by this License Agreement.Other companies manufacturing similar products to petitioner which had patents of their own entered into licensing arrangements with Flowers to use his patents in order to settle prolonged patent litigation and save the expense of further law suits, etc.
The royalty to be paid Flowers by other companies varied from $ 150 per unit to a maximum of $ 280 per unit, depending upon the size of the vehicle but, in no event, did the total royalty paid on any dumping car exceed 3 per cent of the delivered selling price of the complete dumping car. The amounts of these royalties were fixed after extended patent litigation and to some extent represented compromise amounts.
*422 The inventions upon which patents were obtained by Flowers, and which were utilized by petitioner in the manufacture and sale of its products (petitioner paying royalties thereon) were valuable to the coal and iron mining industries, effecting substantial economies in operation, as well as permitting operations which were theretofore not possible.
With respect to the railway type dump car, the patented features of the "Differential" type car permitted the cargo to be discharged*292 from either side, and at a greater distance from the tracks than had been theretofore possible, the side dropping partially down and locking to form a chute through which the cargo could be discharged, with the car pivoting upon either side instead of the middle. In addition, the gate mechanism was so constructed as to prevent accidental spillage, which spillage had theretofore been a definite nuisance and expense.
With respect to the mine cars produced by Differential, the patented features permitted much longer cars to be used in the mines than had been theretofore possible, by utilizing an "axless" construction in the wheel assembly which permitted the wheels to act as casters. Such feature permitted these cars to negotiate the sharp mine-tunnel curves at higher speeds and with greater loads than ever before.
Automatic coal-loading machines in the mines, to be utilized to the full extent of their capabilities, required larger capacity coal cars to be positioned near them for loading purposes, in order to*453 minimize the transportation time consumed in pulling a loaded car out of the mine and replacing it with an empty one. The narrow and low ceilinged mine tunnels prohibited the*293 enlargement of such cars in an upward or sideward direction. Elongation was likewise prohibited due to the sharp curves in the tunnels -- except through the utilization of the "caster type" improvements which were embodied in the Differential car and which were covered by the patents upon which Differential paid royalties. Consequently, such patented features represented a marked improvement of great value in the coal mining industry.
A dump car using the features covered by the Flowers patents was worth at least $ 1,000 more to concerns using the car than one without such features. The royalties paid by petitioner during the taxable years were reasonable.
Throughout the years 1922 to 1944, inclusive, petitioner paid a total of $ 744,360.91 as royalties under the licensing arrangement on patents in the name of Henry Fort Flowers. During the same period petitioner paid out a total of $ 24,224.18 in dividends, including $ 1,375.23 on its common stock.
The following is a schedule for the years 1940 through 1944 showing *423 petitioner's gross sales, claimed royalties paid, net income before taxes, and dividends paid:
| Net profit | ||||
| before Federal | Dividends | |||
| Year | Gross sales | Royalties paid | income tax | paid |
| 1940 | $ 627,875.61 | $ 82,696.55 | $ 1,720.27 | $ 180.95 |
| 1941 | 901,800.37 | 126,548.00 | 27,162.77 | 180.95 |
| 1942 | 835,319.19 | 89,094.45 | 27,917.80 | 180.95 |
| 1943 | 804,347.31 | 120,000.00 | 56,489.80 | 180.95 |
| 1944 | 700,790.66 | 95,250.00 | 29,498.76 | 180.95 |
*294 The petitioner's and its predecessors' gross income from 1921 to 1944, inclusive, varied on the annual basis from a low of $ 47,973.53 in 1933 to a high of $ 901,800.37 in 1941.
In 1943 on gross sales of $ 804,347.31 petitioner showed a profit, after deduction of direct production costs (including royalties), of $ 179,454.24. ** Such profit would have been even higher except that petitioner sustained a substantial loss on a contract involving a new type of equipment furnished to the Bolivian Government, such loss (before royalties) being $ 11,877.49.
In 1944 on gross sales of $ 700,790.66 petitioner showed a profit, after deduction of direct production costs (including royalties) of $ 186,073.47. **
*295 At the end of 1921, the net worth of petitioner's predecessor was $ 13,737.96. Petitioner or its predecessor sustained operating losses in the years 1926, 1931, 1932, and 1934-1936, inclusive, during none of which years did it pay any royalties. At the end of 1944 petitioner's net worth amounted to $ 109,994.56.
Some of the persons to whom the royalties were paid pursuant to their claimed interests therein were also stockholders in petitioner and their proportionate shares in the royalties bore a proportionate relation to their stockholdings.
Opinion -- Issue No. 3.
The question here is essentially one of fact -- whether the disbursements by petitioner were royalty payments and so deductible as "ordinary and necessary expenses" in carrying on business under
The record owner of the patents for the use of which the payments were made was the major stockholder of petitioner. The amounts involved were paid over to persons most of whom were also stockholders, *424 and there is an arresting*296 disparity over the years between the total royalty payments and total dividends. These facts not only invite, they demand, close scrutiny.
Of course, if the record establishes that the payments were in fact royalty payments and not the distribution of profits petitioner would be entitled to the claimed deductions.
We find no reason to doubt the honesty and good faith of the patent licensing agreements. The arrangement had its genesis as early as 1922, very*454 shortly after formation of petitioner's predecessor when the profit pattern was not yet established and in the days when tax saving devices had not assumed their later importance. That the arrangement was not reduced to writing*297 until 1938 is not important. The written agreement of that year and the 1943 memorandum agreement under which the payments here in question were made, closely followed the previous practice of the parties. There was nothing sham about these agreements.
Over the years the schedule of royalty payments remained the same and royalties were computed at a fixed amount per unit manufactured. The arrangement was prospective as contrasted with the plan to pay retroactively, which was involved in
In cases like this when the principal stockholders of a corporation are also holders of interests in the patents and receive the royalty payments, *298 it is easy to say that the transactions were not at arm's length and thus clothe the situation with an aura of suspicion. But we cannot decide cases on suspicion Transactions of like character are not uncommon in the corporate world. See
We have found that the patented devices utilized by petitioner were valuable to the industries which purchased petitioner's products, in effecting substantial economies in operation as well as permitting operations therefore not possible. In the circumstances, we think *425 petitioner was justified in paying for the use of the patents so utilized as an expense of carrying on its business.
The question then is, whether the amounts paid were reasonable. On this point we attach weight to the testimony of a witness with broad experience over a 25-year period in the mining industry which utilized petitioner's equipment, that a dump car using the patented features would be worth at least $ 1,000 more than a car without such features. This figure tallies with the royalty schedule contained in the licensing agreement. We think the fees paid were reasonable.
*299 Respondent makes much of the comparison between the amounts of the royalty payments and the dividend payments made by petitioner. The former were large, the latter small. But that alone does not determine the reasonableness or legitimacy of the royalties. Despite their dollar amount the royalties did not syphon off all profits, nor do we find any design to do so. As pointed out before, the royalty per unit was fixed long before the tax years in question and had no relation to the profits petitioner might make. As a matter of fact, petitioner in 1943 had a profit of $ 179,454.24 on gross sales of $ 804,347.31 after deduction of direct production costs including royalties and in 1944 a profit of $ 186,073.47 on gross sales of $ 700,790.66 after similar deductions. Also, as petitioner emphasizes, its net worth increased from $ 13,737.96 in 1921 to $ 109,994.56 in 1944 despite operating losses in the years 1926, 1931, 1932, and 1934-1936, inclusive.
We conclude that respondent erred in disallowing as deductions from gross income the amounts of $ 120,000 and $ 95,250 paid as royalties for the calendar years 1943 and 1944, respectively.
Decision will be entered under Rule 50*300 .
Footnotes
1.
SEC. 721 . ABNORMALITIES IN INCOME IN TAXABLE PERIOD.(a) Definitions. -- For the purposes of this section --
(1) Abnormal income. -- The term "abnormal income" means income of any class includible in the gross income of the taxpayer for any taxable year under this subchapter if it is abnormal for the taxpayer to derive income of such class, * * *↩
2.
SEC. 718 . EQUITY INVESTED CAPITAL.(a) Definition. -- The equity invested 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 amounts, reduced as provided in subsection (b) --
* * * *
(7) Deficit in earnings and profits of another corporation. -- In the case of a transferee, as defined in subsection (c) (5), an amount, determined under such paragraph, equal to the portion of the deficit in earnings and profits of a transferor attributable to property received previously to such day.
* * * *
(c) Rules for Application of Subsections (a) and (b). -- For the purposes of subsections (a) and (b) --
* * * *
(5) Deficit in earnings and profits. -- Earnings and profits of transferor and transferee. -- If a corporation (hereinafter called "transferor") transfers substantially all its property to another corporation formed to acquire such property (hereinafter called "transferee"), if --
(A) the sole consideration for the transfer of such property is the transfer to the transferor or its shareholders of all the stock of all classes (except qualifying shares) of the transferee. * * *
(B) the basis of the property, in the hands of the transferee, for the purposes of this subsection, is determined by reference to the basis of the property in the hands of the transferor;
(C) the transferor is forthwith completely liquidated in pursuance of the plan under which the acquisition of the property is made; and
(D) immediately after the liquidation the shareholders of the transferor own all such stock; * * *↩
**. These figures are reconcilable with "Net Profit Before Federal Income Tax" in above table by adding to "direct production costs" items of "unallocated overhead" amounting to $ 127,739.48 in 1943 and $ 156,574.71 in 1944.↩
**. These figures are reconcilable with "Net Profit Before Federal Income Tax" in above table by adding to "direct production costs" items of "unallocated overhead" amounting to $ 127,739.48 in 1943 and $ 156,574.71 in 1944.↩