Opinion
Docket No. 66616.
1960-01-28
McCULLOUGH TOOL COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Wilson B. Copes, Esq., and James E. Harrington, Esq., for the petitioner. Richard W. Janes, Esq., and Cyrus Johnson, Esq., for the respondent.
Wilson B. Copes, Esq., and James E. Harrington, Esq., for the petitioner. Richard W. Janes, Esq., and Cyrus Johnson, Esq., for the respondent.
In 1944 and 1947, petitioner became the exclusive licensee under certain patents by agreements, terminable without default only by petitioner upon written notice, and providing for royalty payments computed upon gross receipts. In 1950, petitioner and its licensors executed modification agreements which provided for the unconditional sale of the patents for agreed prices, the payment of which was to be made in installments. Held, by the execution of the modification agreements, petitioner acquired fixed costs for the patents, susceptible of depreciation. Held, further, the installment obligations of petitioner under the modification agreements did not represent borrowed capital under section 439, I.R.C. 1939, to be used in computing petitioner's excess profits credit under the statute.
The respondent has determined deficiencies in petitioner's income and excess profits taxes as follows:
+-------------------+ ¦Year ¦Amount ¦ +------+------------¦ ¦1951 ¦$104,690.01 ¦ +------+------------¦ ¦1952 ¦86,898.80 ¦ +-------------------+
The deficiencies arise from respondent's disallowance of deductions for depreciation of certain patents and disallowance of the inclusion of certain sums as borrowed capital in the computation of petitioner's excess profits credit. Respondent allowed the deduction of certain payments with respect to the patents as business expenses by way of royalties. None of those payments were claimed by petitioner as deductions on its tax returns for the 2 years in question. Petitioner, instead of claiming deductions for royalties, claimed deductions for depreciation of the patents.
The issues here presented are: (1) Whether by modification agreements executed in 1950 petitioner acquired a fixed cost susceptible of depreciation for certain patents previously used under exclusive license agreements under which royalties were paid, and (2) whether the modification agreements created an outstanding indebtedness includible as borrowed capital in the computation of petitioner's excess profits credit.
FINDINGS OF FACT.
A stipulation of facts has been filed by the parties and is incorporated herein by this reference.
The petitioner is a corporation organized under the laws of the State of Nevada, with its principal place of business at Los Angeles, California. It filed its corporation income tax return for the year 1951 with the collector of internal revenue, Los Angeles, and its return for 1952 with the director of internal revenue, Los Angeles.
At all times pertinent herein 80 per cent of the stock of petitioner was owned by I. J. McCullough and 20 per cent was owned by his brother, O. J. McCullough. I. J. McCullough and O. J. McCullough are sometimes hereinafter referred to as the McCulloughs.
Since its inception in 1941 petitioner has been and is now engaged in the rendition of perforating and other highly specialized services to the oil-drilling industry. The business in which petitioner is engaged is highly competitive and approximately 75 per cent of such business is founded on a number of patents which it either owns or is licensed to use.
Prior to January 1, 1944, the McCulloughs were the owners of certain patents (hereinafter referred to as the bullet patents) governing the manufacture, use, and sale of bullet-like projectiles for the perforation of oil wells.
On January 1, 1944, petitioner and the McCulloughs entered into an agreement whereby petitioner received an exclusive license to make, use, and sell devices manufactured in accordance with the bullet patents. The agreement provided, inter alia:
1.
The Licensors hereby grant to the Licensee, upon and subject to the conditions, covenants, restrictions and terms hereinafter contained, the full and exclusive right and license during the continuance of this agreement to make, use and sell throughout the United States, its territories and possessions, devices made in accordance or disclosed in the aforesaid patents set forth on Exhibit A for the full term of said patents and until the expiration date of the last of said patents.
2.
It is mutually understood and agreed that the license granted in Paragraph 1 hereof is granted subject to the conditions that it does not and shall not empower the Licensee, directly or indirectly, to license any other person or persons, natural or artificial, to use said patents.
4.
The Licensee further agrees to keep books, records, and accounts of all work performed during the life of this agreement of all work done hereunder, and all such records or accounts shall at and during the usual business hours be open to the inspection of the Licensors or their duly authorized representative.
5.
On or before the 15th day of each calendar month after the execution hereof and during the continuance of this agreement, the Licensee shall mail a statement to each of the Licensors containing the information required in Paragraph 4, hereof, showing all charges for use and sales by the Licensee under this agreement during the next preceeding (sic) calendar month.
6.
In consideration of the rights and licenses herein given and granted by the Licensors to the Licensee, the Licensee agrees to pay to the Licensors at the time of rendering the statement required by Paragraph 5 hereof, a royalty consisting of a sum equal to twelve and one-half per cent (12 1/2%) of the total gross price charged by the Licensee for all gun perforating done and all sales of parts and equipment in accordance with the herein license and patents, and one-fourth (1/4) of the said royalty shall be paid to the Licensor O. J. McCULLOUGH and three-fourths (3/4) of the said royalty shall be paid to the Licensor I. J. McCULLOUGH.
7.
The Licensee shall have the right to terminate this agreement upon first giving ninety day notice in writing to the Licensors to cancel and terminate this agreement together with all rights, licenses and obligations hereunder, provided, however, that no such termination or cancellation shall relieve the Licensee from the payment of any royalty due and payable to the Licensors at the time of such termination.
8.
In the event that either party shall violate any covenants of this agreement, the aggrieved party may give to the defaulting party written notice of such breach accompanied by sufficient particulars to reasonably enable the defaulting party to determine the alleged nature and extent of the breach, and if the defaulting party shall fail for a period of thirty days after the service of such notice to remedy such breach, the aggrieved party may, at its option, terminate and cancel this agreement and all of the rights and licenses of any defaulting party hereunder. The waiver of any particular breach or breaches by the aggrieved party shall not be deemed to constitute a waiver of any continuing breach or of any future breach by the defaulting party of this agreement.
On October 1, 1947, petitioner entered into an exclusive license agreement with Earl J. Robishaw and William G. Sweetman regarding several patent applications (hereinafter referred to as the jet patents) governing the manufacture, use, and sale of shaped charges of explosives for the perforation of oil wells, devices sometimes known as jet perforators. The process of jet perforation of oil wells covered by the jet patents was not sufficiently developed at the time of the agreement to be commercially usable. Petitioner under the agreement undertook the responsibility and expense of further development of the jet patents. In all other material respects the agreement was similar to the agreement for the bullet patents except as to the amount of royalty, the length of periods for notice of termination, and the transferability of the license. The agreement makes no mention of the right to grant sublicenses.
Neither Robishaw nor Sweetman was an employee of petitioner on October 1, 1947.
In July 1948, each of the McCulloughs acquired a 25 per cent interest in the jet patents. At that time the jet patents were still not commercially usable.
On December 28, 1950, the McCulloughs and petitioner executed a document entitled ‘Modification Agreement’ which provided:
WHEREAS, the parties hereto on the first day of January, 1944 did make and enter into an Agreement by which the (McCulloughs) sold to the (petitioner) certain patents and patent applications listed on Exhibit ‘A’ attached thereto; and
WHEREAS, said Agreement was termed a ‘License Agreement’ and the parties thereto were referred to as Licensors and Licensee, respectively, although the Agreement was intended to be, and, in law, was actually an agreement of sale; and
WHEREAS, Paragraph 6 of said Agreement provided for payments to the (McCulloughs), which payments were termed ‘royalty’, of 12 1/2% of the total gross price received by the (petitioner) for services and sales under the said patents and patent applications; and
WHEREAS, the parties are desirous of modifying said provision for payment and substituting therefor a fixed and determinable total remaining price to be paid by the (petitioner) in consideration for the sale of the said patents;
NOW, THEREFORE, in consideration of the mutual promises of the parties hereto, IT IS AGREED AS FOLLOWS:
1. Paragraph 6 of said Agreement of January 1, 1944 is modified to read as follows:
‘6.
‘In consideration of the rights in and to the patents and patent applications transferred, assigned and sold by the (McCulloughs) to the (petitioner), the (petitioner) hereby agrees to pay to the (McCulloughs), in addition to all other payments heretofore made hereunder, $20,000.00 per month on the 28th day of each calendar month, commencing on the 28th day of December, 1950, for a period of six years and one month. The last of said monthly payments shall be due and payable on the 28th day of December, 1956. One-fourth of each of said monthly payments, or $5,000.00, shall be paid to O. J. McCULLOUGH, and three-fourths of said monthly payments, or $15,000.00, shall be paid to I. J. McCULLOUGH. The parties are agreed that the total of these payments, $1,460,000.00, shall be the full remaining price to be paid by the (petitioner) for the complete and absolute ownership of the patents and patent applications described in Exhibit ‘A’.'
2. It is agreed by the parties hereto that any and all provisions of said Agreement of January 1, 1944 which are inconsistent with this Modification Agreement shall have no effect. Said Agreement of January 1, 1944 has been considered by the parties thereto as an absolute assignment or sale of the subject matter thereof. That Agreement together with this Modification thereof shall be similarly construed hereafter.
On December 28, 1950, the parties to the jet patent agreement or their assignees entered into similar modification agreements, effect of which, inter alia, was to substitute the total price of $2,870,000 for the payment of a royalty. In all other respects the agreements were almost identical to the modification agreement relating to bullet patents.
Petitioner made all payments for the bullet patents due the McCulloughs under the modification agreement. Petitioner's gross sales of parts and services under the bullet patents, the royalty payable thereon which would have been paid under the agreement of January 1, 1944, the actual payments made under the modification agreement, and the excess of what royalty payments would have been paid under the agreement of January 1, 1944, over actual payments for the years 1950 to 1958 are as follows:
+--------------------------------------------------------+ ¦ ¦ ¦ ¦Actual ¦ ¦ +--------+-------------+-----------+--------+------------¦ ¦Year ¦Sales ¦Royalty ¦payments¦Excess ¦ +--------+-------------+-----------+--------+------------¦ ¦1950 1 ¦ ¦ ¦$20,000 ¦($20,000,00)¦ +--------+-------------+-----------+--------+------------¦ ¦1951 ¦$2,073,301.88¦$259,162.74¦240,000 ¦19,162.74 ¦ +--------+-------------+-----------+--------+------------¦ ¦1952 ¦2,311,565.79 ¦288,945.72 ¦240,000 ¦48,945.72 ¦ +--------+-------------+-----------+--------+------------¦ ¦1953 ¦2,908,134.84 ¦363,516.86 ¦240,000 ¦123,516.86 ¦ +--------+-------------+-----------+--------+------------¦ ¦1954 ¦3,140,828.54 ¦392,603.57 ¦240,000 ¦152,603.57 ¦ +--------+-------------+-----------+--------+------------¦ ¦1955 ¦3,268,037.83 ¦408,504.73 ¦240,000 ¦168,504.73 ¦ +--------+-------------+-----------+--------+------------¦ ¦1956 ¦3,948,232.27 ¦493,529.03 ¦240,000 ¦253,529.03 ¦ +--------+-------------+-----------+--------+------------¦ ¦1957 ¦2,688,173.28 ¦336,021.66 ¦ ¦336,021.66 ¦ +--------+-------------+-----------+--------+------------¦ ¦1958 ¦2,250,591.30 ¦281,323.91 ¦ ¦281,323.91 ¦ +--------------------------------------------------------+
22,588,865.73 2,823,608.22 1,460,000 2 1,363,608.22
Petitioner has made all payments for the jet patents due to the owners or assignees under the modification agreement. Petitioner has made no attempt to terminate the agreement and in 1952 made advances to one of the parties of payments due for the 5 years next ensuing. Petitioner's gross sales of parts and services under the jet patents, the royalty payable thereon if such royalty payments had been made under the agreement of October 1, 1947, the actual payments made under the modification agreement, and the excess of what royalty payments would have been made under the contract of October 1, 1947, over actual payments for the years 1950 to 1958 are as follows:
+--------------------------------------------------------+ ¦ ¦ ¦ ¦Actual ¦ ¦ +--------+-------------+-----------+--------+------------¦ ¦Year ¦Sales ¦Royalty ¦payments¦Excess ¦ +--------+-------------+-----------+--------+------------¦ ¦1950 1 ¦ ¦ ¦$14,000 ¦($14,000.00)¦ +--------+-------------+-----------+--------+------------¦ ¦1951 ¦$2,391,904.25¦$239,190.43¦168,000 ¦71,190.43 ¦ +--------+-------------+-----------+--------+------------¦ ¦1952 ¦2,953,871.53 ¦295,387.15 ¦168,000 ¦127,387.15 ¦ +--------+-------------+-----------+--------+------------¦ ¦1953 ¦3,323,230.48 ¦332,323.05 ¦168,000 ¦164,323.05 ¦ +--------+-------------+-----------+--------+------------¦ ¦1954 ¦3,478,612.41 ¦347,861.24 ¦168,000 ¦179,861.24 ¦ +--------+-------------+-----------+--------+------------¦ ¦1955 ¦4,012,038.67 ¦401,203.87 ¦168,000 ¦233,203.87 ¦ +--------+-------------+-----------+--------+------------¦ ¦1956 ¦4,490,768.51 ¦449,076.85 ¦168,000 ¦281,076.85 ¦ +--------+-------------+-----------+--------+------------¦ ¦1957 ¦3,799,971.39 ¦379,997.14 ¦168,000 ¦211,997.14 ¦ +--------+-------------+-----------+--------+------------¦ ¦1958 ¦3,569,073.75 ¦356,907.38 ¦168,000 ¦188,907.38 ¦ +--------------------------------------------------------+
28,019,470.99 2,801,947.11 1,358,000 1,443,947.11
of the 1939 Code;
Under the modification agreement of Dec. 28, 1950, the fixed payment terminated December 1956. Under the prior license agreement of Jan. 1, 1944, the royalty payments would have continued until approximately 1968.
or whether, as respondent has determined, the agreements as modified failed to accomplish a fixed price for the patents. Respondent has disallowed petitioner's claim for depreciation on the patents and in lieu of depreciation, has allowed petitioner a deduction in each of the taxable years of $324,000 as deductible royalties under the licensing agreements of 1944 and 1947 within the provisions of section 23(a)(1) (A).
1December only.
Petitioner incurred its obligations under the modification agreements of 1950 in good faith and for the purposes of its business.
Subsequent to the hearing and the filing of briefs in this proceeding, the parties filed a stipulation designated as ‘Stipulation With Respect to Definition of Issues' in which, among other things, it is stipulated:
5. Respondent concedes that should the Court find that petitioner is not entitled to deductions in the nature of depreciation or amortization, then petitioner should be permitted to deduct as ‘royalty’ expense the amounts actually paid out as such in each of the years in issue, which amounts are stipulated as $408,000.00 for each of the two years.
6. Should, however, the Court find that petitioner is entitled to deductions in the nature of depreciation or amortization by reason of the fact that the 1950 modification agreements created a fixed cost, then the parties request that the Court hand down a Rule 50 opinion in this regard so as to enable the parties to determine the remaining lives of the various patents involved or to otherwise determine the proper amount of the depreciation deductions.
OPINION.
BLACK, Judge:
The first issue here presented is whether, as petitioner contends, sums paid in 1951 and 1952 by petitioner under the jet patent and bullet patent agreements of 1947 and 1944, respectively, as modified by the 1950 agreements, were paid to acquire depreciable capital assets of a fixed cost and, therefore, whether petitioner is entitled to deduct depreciation on the patents under section 23(l)(1)