Docket No. 2379.
Ewing Everett, Esq., for the petitioner. Francis X. Gallagher, Esq., for the respondent.
1. Petitioner corporation entered into a contract whereby it guaranteed 30 percent of a principal debt of its wholly owned subsidiary and agreed to pay interest thereon at the rate of 3 percent per annum until the principal was paid. Held, that the annual payments are not deductible as interest within the meaning of section 23(b) of the Internal Revenue Code, as they were not interest payments on the indebtedness of the taxpayer, but of another.
2. The interest payments, which were made primarily for the purpose of protecting petitioner's capital investment in the subsidiary, are capital expenditures and are not deductible as ordinary and necessary business expenses.
3. The so-called royalty payments which petitioner contracted to pay were not ordinary and necessary expenses of carrying on petitioner's trade.or business. Ewing Everett, Esq., for the petitioner. Francis X. Gallagher, Esq., for the respondent.
The Commissioner has determined deficiencies in the petitioner's income tax of $4,710.53 for 1938 and $4,157.70 for 1939.
The two issues involved are: (1) Whether certain payments, called royalties, accrued by petitioner and deducted by it from gross income, may properly be deducted, and (2) whether petitioner is entitled to a deduction from gross income for certain interest charges accrued by it during the taxable years.
Other issues raised by the parties were not pressed at the hearing and no proof was presented by petitioner.
Many of the facts have been stipulated by the parties and are found as stipulated. Other material facts are found from the evidence.
FINDINGS OF FACT.
The petitioner, Eskimo Pie Corporation, is a Delaware Corporation, organized August 14, 1922. It keeps its books and makes its tax returns on an accrual basis. Federal income tax returns for the taxable years involved were filed with the collector of internal revenue for the fifth collection district of New Jersey.
Prior to 1922 C. K. Nelson owned and held the patents and trade name of ‘Eskimo Pie.‘ At the time petitioner was organized the patents and trade name were turned over to it and have continuously been the property of petitioner. C. K. Nelson, C. F. Wade, C. O. Lund, and W. J. Hamlin owned the majority of petitioner's shares. Petitioner is not a distributor of Eskimo Pies. It licenses ice cream manufacturers in various localities to manufacture Eskimo Pie products under its trade name, in accordance with standards and formulae established by it. The patent expired prior to the taxable period involved herein.
The license agreements between petitioner and its manufacturer licensees provided that Eskimo Pie products would be sold only in foil wrappers to be purchased only from foil suppliers designated by petitioner. Among the foil suppliers designated was the United States Foil Co., hereinafter referred to as Foil, a Delaware corporation, organized in 1919. Under a contract in effect between petitioner and Foil, the latter would ship the wrappers to petitioner's licensees and collect from them. Foil would remit to petitioner $1 per 1,000 wrappers sold by it. This method of operation between petitioner and Foil continued until June 28, 1928.
In 1924 Foil, being desirous of obtaining more of petitioner's wrapper business, attempted to purchase for a cash consideration the respective shares owned by the following individuals: Nelson 14,768, Wade 14,300, Lund 5,250, and Hamlin 5,000. These persons will hereinafter be called the individuals. The individuals refused to sell for a cash consideration and demanded that they be paid a so-called royalty, hereinafter for convenience called ‘royalty payments,‘ on all foil and/or other wrappers which were used on Eskimo Pies. Individual contracts between Nelson, Wade, and Lund and Foil were executed on July 31, 1924, and an individual contract between Foil and Hamlin was entered into on May 20, 1925. Under these contracts Foil acquired the shares owned by the individuals and agreed to pay them royalties, computed at rates ranging from 10 cents up to 15 cents per 1,000 wrappers with respect to all foil and/or other wrappers used on Eskimo Pies and/or other edible coated ice cream bars. In 1924 Foil also purchased outright 3,240 shares of petitioner's stock from other owners. During the years 1925 to 1928, inclusive, Foil paid a total of $259,283.50 in royalty payments.
On June 28, 1928, petitioner granted Foil an exclusive license to manufacture, sell, and distribute metallic foil wrappers to petitioner's licensees engaged in the manufacture of Eskimo Pie products. Foil agreed to pay petitioner $1 per 1,000 wrappers sold and to allow petitioner 20 cents per 1,000 wrappers as an advertising allowance. This exclusive license had a 25-year duration under the terms of the contract.
In July 1928 the Reynolds Metals Co., a Delaware corporation, hereinafter called Metals, was organized. Metals took over the operating assets and liabilities of Foil, including its agreement with petitioner and the contracts with the individuals. Shortly thereafter, because of objections raised by the individuals, Metals reassigned the contracts between Foil and the individuals to Foil. In this agreement Metals obligated itself to pay Foil amounts sufficient to pay Foil's royalty payment obligations under revised contracts with the individuals. Foil retained the stock of petitioner it had acquired from the individuals and from other owners.
Metals, as assignee of Foil, operated under the exclusive agreement until November 1, 1928, when a new exclusive license agreement for a 10-year period was entered into between Metals and petitioner. All previous agreements were terminated and superseded by the contract. Payments to petitioners were increased to $1.45 per thousand. From the time of its organization until October 12, 1931, Metals manufactured the wrappers and sold them to petitioner's licensees. It paid petitioner as per its contracts and paid to Foil the royalty payments. Foil, in turn, paid the individuals. This contract was superseded by a new contract dated April 2, 1930, ending September 1, 1939, which provided the same as above, and made changes not material herein.
On October 12, 1931, a new contract between Metals and petitioner was executed and was to be in force and effect for five years from that date. It provided that Metals would sell all Eskimo Pie wrappers to petitioner for a period of five years at scheduled prices. Under this contract petitioner collected for the wrappers from its licensees and paid Metals for the wrappers, including the amount of royalty payments. Metals paid Foil, which in turn paid the individuals. Upon execution of this contract, the contract of April 2, 1930, ceased and terminated.
A supplemental agreement between Metals and petitioner, executed on January 2, 1933, provided that the Eskimo Pie Corporation of New York, hereinafter more fully described, should have the right to use paper bags or wrappers on Eskimo Pies sold by it. While this contract was in effect petitioner paid Metals for all wrappers used and Metals paid the royalties to Foil to be paid by it to the individuals. In 1935 a further supplemental agreement was entered into by Metals and petitioner canceling the above supplemental contract. It provided that petitioner and its licensees and subsidiaries should have the right to use paper wrappers and paper bags on Eskimo Pie products in consideration of petitioner paying to Metals the sum of 33 1/3 cents for each 1,000 wrappers used by petitioner's licensees. All other terms and conditions of the original contract dated October 12, 1931, were to remain in effect. About this time the petitioner company started manufacturing all wrappers used by its licensees. Paper wrappers were adopted because they were considerably cheaper and the nature of the business had changed. The 33 1/3 cents per 1,000 represented the amount of the royalty payments. This sum was paid by petitioner to Metals. The latter company paid Foil, which paid the individuals. This supplemental agreement was executed on December 3, 1935, and was in effect from February 1, 1934, until January 31, 1936.
During the period from January 31, 1936, the expiration date of the supplemental agreement last referred to, until June 1, 1937, there was no written contract between petitioner and Metals requiring petitioner to make royalty payments to Metals. Petitioner continued to send monthly reports to Metals and accrued on its books the royalty payments as an account payable to Metals. By contract dated June 1, 1937, specifically referred to hereinafter, petitioner again became obligated to collect and pay over the royalties during the taxable years here in question.
By contract dated November 22, 1937, between Foil and C. F. Wade, it was agreed that in lieu of the royalty payments theretofore provided for Foil would pay Wade the sum of $4,402.12 upon execution of the contract and $30,000 in installments of $500 per month for five years from December 1, 1937, to December 1, 1942. By contract dated March 2, 1938, between Foil and C. O. Lund, it was agreed that Foil would pay Lund $4,258.33 on execution of the contract and $30,000 payable at the rate of $6,000 per year for five years from March 2, 1938, to March 2, 1942.
By 1937 the Eskimo Pie Corporation of New York, hereinafter called the New York company, petitioner's wholly owned subsidiary, which had previously operated as petitioner's licensee in the New York area, was inactive and insolvent. The New York company had a number of creditors and was seriously in default on its obligations.
Petitioner had been endeavoring to obtain a licensee for the area but had not been successful. From a business standpoint the New York area represented the largest potential market in the country for the distribution of products bearing the petitioner's trade-mark. The territory covered by the area included the State of New Jersey, the metropolitan area of Philadelphia, Pennsylvania, the metropolitan area of New York, extending to the northern boundaries of Dutchess, Ulster, and Sullivan counties, and the counties of Fairfield and New Haven in the State of Connecticut. One of the major obstacles was the finding of a suitable plant and equipment by any prospective licensee.
Foremost Dairies, Inc., with which petitioner had been negotiating, was willing to become the licensee, though it had no plant. The New York company, being inoperative, was willing to lease to Foremost a large suitable plant owned by it and especially adapted to the manufacture of Eskimo Pie products, but Foremost, being aware of the precarious financial condition of the New York company, was unwilling to embark on a tenancy relation unless it could obtain an assurance that it would enjoy a quiet and peaceful tenancy of the premises.
Petitioner was not in a position, financially, to give Foremost Dairies the protection it required. The New York company owned substantial sums to Foil, Metals, and R. S. Reynolds as an individual. R. S. Reynolds, Foil, and Metals had already taken steps to buy up some of the claims of some of the New York company's most pressing creditors for their own protection and had paid 30 cents on the dollar therefor. Petitioner required Foil, Metals, and R. S. Reynolds to assure Foremost Dairies that if it leased the plant its operations would not be interrupted by the creditors.
The negotiations terminated in a written contract executed June 1, 1937, by petitioner, Foil, Metals, and R. S. Reynolds. The contract recited that the New York company had outstanding claims against it aggregating more than $300,000, entitled to immediate payment, and secured and unsecured claims totaling approximately $1,262,787.50. The company was without working capital. The contract stated that the directors of the New York Eskimo Pie Corporation had decided there was no feasible way of continuing the business of the corporation; that Foil and Metals were unwilling to loan additional sums to the New York Eskimo Pie Corporation; and that petitioner was unable to do so. The contract further recited that the petitioner owned all of the outstanding capital stock of the New York company and the same represented an investment by petitioner in excess of $3,000,000, substantially all of which would be lost but for the undertakings of Foil, Metals, and Reynolds as provided in the agreement. It was stated that Foremost Dairies, Inc., was desirous of leasing all of the real and personal property of the New York company and of acquiring from petitioner a license to manufacture and sell Eskimo Pie products. The agreement then recites as follows:
WHEREAS ESKIMO is desirous that New York Eskimo Pie Corporation shall conclude the contemplated lease with said Foremost Dairies Inc., in order to preserve its equity in New York Eskimo Pie Corporation and in order to acquire a licensee in Metropolitan New York who will continue the use of ESKIMO'S trademark s in that area and purchase supplies from ESKIMO; but said FOREMOST Dairies Inc. has refused to conclude the proposed lease unless and unit it is given assurance that its lease will not be interrupted by FOIL, METALS and REYNOLDS, and
WHEREAS ESKIMO is desirous that FOIL, METALS and REYNOLDS as creditors of New York Eskimo Pie Corporation shall undertake to assure Foremost Dairies Inc. that they will not interrupt the tenure of the property of New York Eskimo Pie Corporation by Foremost Dairies Inc., in order that the least may be concluded, and ESKIMO preserve its equitable rights as a stockholder in New York Eskimo Pie Corporation, and also obtain a licensee under its trademarks to keep its trademarked products active in the New York Metropolitan area, and derive profit therefrom by the sale of its products to such licensee, and
The agreement also recited that Foil had originally purchased stock in the petitioner, provided it with an assured source of wrappers for sale to its licensees, loaned it money, guaranteed its obligations, extended credit to it, and performed various other acts necessary to establish a market for and promote the sale of the products of petitioner, and that Metals had performed similar acts after succeeding to the business of Foil, and that petitioner had agreed that it would include in the price of wrappers sold by it to its licensees the amounts of the so-called royalties payable by Foil to the individuals; and that petitioner had, in effect, and according to the intent and understanding among itself, Foil, and Metals, collected in the price of the wrappers sold by it to its licensees an amount to cover payment of the aforesaid royalties. In consideration of all the premises stated, other good, and valuable considerations, petitioner thereafter agreed as follows:
1. ESKIMO hereby guarantees (1) payment of all amounts now owing by New York Eskimo Pie Corporation to FOIL, METALS and REYNOLDS, to the extent only of 30% of the principal amount thereof (whether said amounts represent direct advances, credits, guarantees or claims purchased by any of them from others); (2) all amounts now owing by New York Eskimo Pie Corporation which FOIL, METALS and REYNOLDS or any of them, may purchase in the future, but only to the extent of 30% of the principal amount thereof.
2. ESKIMO hereby agrees to pay interest at the rate of 3% per annum on all amounts guaranteed under paragraph numbered 1 hereof, from January 1, 1937 until paid, payable on the 31st day of December each year.
4. ESKIMO shall include in its price of wrappers to its licensees and pay to Metals the amounts (within 10 days after each calendar month) which Metals is required to pay FOIL and which FOIL is required to pay C. O. Lund, C. F. Wade, C. K. Nelson and W. J. Hamlin by reason of said parties' contracts with FOIL, or any renewals, extensions, amendments or supplements thereof or thereto, or contract entered into in lieu thereof.
The contract was carried out by the parties and Foremost Dairies leased the plant from the New York company and became petitioner's New York licensee.
During the years 1938 to 1942, petitioner's net income from the New York licensee, after deducting the royalty payments and the whole of the annual interest which petitioner had obligated itself to pay, constituted approximately 10 percent of petitioner's total net income from all sources. During the same period the New York company received a total of $110,241.06 as rental payments from petitioner's licensees for the use of the plant and facilities.
Petitioner accrued on its books in pursuance of its agreement of June 1, 1937, amounts necessary to pay Metals the so-called royalties hereinbefore described. In the notice of deficiency respondent disallowed as a deduction items of $11,000 in 1938 and $12,000 in 1939 under the caption ‘royalties.‘
Petitioner accrued on its books the interest items as interest payable during the respective years. It did not set up on its books of account or otherwise claim that it was entitled to reimbursement from the New York company, nor did that company set up on its books any amounts to indicate it was obligated to reimburse petitioner for such interest. During the taxable years the interest accrued by petitioner was not actually paid. Owing to financial difficulties, for a four-year period, the interest items were included in a note given by petitioner. In later years the current interest accruals were paid in cash. The respondent in his notice of deficiency disallowed as a deduction the amounts claimed in petitioner's returns as ‘interest‘ in the amounts of $9,724.37 for 1938 and $9,805.90 for 1939.
On June 1, 1937, Foil owned 53 percent of the voting stock of Metals. The voting stock was common of no par value and has been listed continuously on the New York Stock Exchange since April 10, 1930. Metals 5 1/2 percent cumulative preferred stock is also listed on that exchange. On June 1, 1937, Foil owned 37.4 percent of the preferred stock, 99.98 percent of the common A stock, and 77.7 percent of the common B stock of petitioner. Common A is petitioner's only voting stock. On June 1, 1937, 74 percent of the common A stock of Foil, 9 percent of its common B stock, and 1 percent of its preferred stock were owned by R. S. Reynolds and his family. The common A stock was Foil's only voting stock.
Petitioner, Foil, Metals, and the New York company kept their books and made their tax returns on an accrual basis of accounting.
Two deductions are sought by petitioner. First is the interest on that part of the debts of petitioner's New York subsidiary which petitioner had guaranteed, and the second is the royalty payments described in some detail in our findings of fact. The first item petitioner seeks to deduct as interest qua interest, but in the alternative it seeks the deduction as an ordinary and necessary expense. Deduction of the royalty payments is likewise sought as an ordinary and necessary expense.
Petitioner has guaranteed the payment of 30 percent of the principal indebtedness of its New York subsidiary held by Foil, Metals, and Reynolds, and has undertaken to pay interest at the rate of 3 percent per annum thereon until the principle sum is paid. During the taxable years petitioner's liability was purely contingent; the indebtedness was that of the subsidiary and not petitioner; and the interest which it accrued and seeks to deduct was interest on the indebtedness of another. The statutory deduction for interest is confined to amounts chargeable against the taxpayer on his own indebtedness, and he may not deduct interest on the indebtedness of another, even though he has by legal contract agreed to pay such interest. William H. Simon, 36 B.T.A. 184; Orange Securities Corporation, 45 B.T.A. 24; William Ainslie Colston, 59 Fed.(2d) 867; certiorari denied, 287 U.S. 640; Caldwell & Co., 26 B.T.A. 790; affd., 65 Fed.(2d) 1012; Automatic Sprinkler Co. of America, 27 B.T.A. 160.
Petitioner's alternative argument, that the interest is deductible as an ordinary and necessary expense, we believe is likewise without merit. Petitioner had an investment of its New York subsidiary of approximately $3,000,000, the subsidiary was at the time insolvent, and if the creditors pushed their claims petitioner's entire investment in that company would be sacrificed. It is true that petitioner was likewise interested in securing a licensee for the metropolitan New York area, but that it would have obligated itself to the extent it did if it had been dealing with a total stranger is at least problematical. It was guaranteeing debts of some $300,000 to $400,000 and under the circumstances here the benefits of the contract flowed directly to the New York subsidiary and not to petitioner. As a result of the undertaking New York Eskimo Pie was renting its plant and property for a substantial sum and it was given at least a breathing spell by its creditors. Payments made by a stockholder of a corporation for the purpose of protecting his interest therein must be regarded as additional cost of his stock and such sums may not be deducted as ordinary and necessary expenses. W. F. Bavinger, 22 B.T.A. 1239; Michigan Central Railroad Co., 79 Fed.(2d) 427, affirming 28 B.T.A. 437, 444, on this point. We do not believe it could be seriously argued that, if petitioner were required to make good on its guaranty to the extent of hundreds of thousands of dollars, under the circumstances here present, it could claim such sums as ordinary and necessary expense, and yet, in our view of the case, the interest stands on no better ground than the principal sums guaranteed. It is, of course, true that upon winding up the whole investment petitioner might well have a loss, but that is another matter and both the time of the deduction and the extent of the deduction would be governed by other sections of the Internal Revenue Code. Even if we accept petitioner's premise that the securing of a licensee was a consideration for its undertaking to guarantee the debts and pay the interest thereon, there is nothing in this record which would permit of an allocation of the interest payments between the protection of petitioner's equity in the New York company and the securing of a licensee. Sentinel Realty Co., 19 B.T.A. 991; Houston Natural Gas Corporation v. Commissioner, 90 Fed.(2d) 814.
There remains for disposition the question whether the royalty payments may be deducted as ordinary and necessary expense. At the outset it is well to have in mind the relationship which exists between the several parties to the contract of June 1, 1937. All of the stock of Metals to which the royalties were to flow directly was owned by Foil; Foil owned all of the voting stock of petitioner and some of the preferred shares; and R. S. Reynolds and his family controlled Foil. Foil had acquired its stockholdings in petitioner from four individuals under a contract which provided that payment for the shares be in the form of royalties rather than at an upset price. Metals, when it entered the picture, assumed the manufacturing contract of Foil and agreed to pay the latter a sum sufficient for it to pay the royalties to the four individuals. The royalties in question which are sought to be deducted by petitioner are in a sum equivalent to the obligation of Metals to Foil and Foil to the four individuals.
It is not questioned by respondent, and we do not question the fact, that petitioner became obligated to make these so-called royalty payments by reason of the contract of June 1, 1937. The mere fact that an expense was incurred under a contractual obligation, however, does not make it the equivalent of a rightful deduction under section 23(a). Interstate Transit Lines v. Commissioner, 319 U.S. 590. The Supreme Court has ruled that a voluntary payment of an obligation of another is not ‘ordinary‘ within the meaning of the statute. Welch v. Helvering, 290 U.S. 111; Deputy v. DuPont, 308 U.S. 488.
At the time the contract of June 1, 1937, was entered into there was no outstanding obligation on the part of petitioner to make royalty payments to Metals or Foil. The expiration date of the last written contract calling for such royalty payments was January 31, 1936. The basis for the renewal of this obligation is set forth in the June 1, 1937, contract and appears to be grounded on the close relationship existing between the several parties to the agreement and what Metals and Foil have done from time to time for petitioner. The provision in the contract calling for payment of royalties appears to be a statement of what the parties regard as a fair thing to do in the circu mstances, considering it is a transaction between closely related companies. In the final analysis it calls upon petitioner to collect from its licensees and pay Metals a sum of money equal to that which Foil was obligated to pay the individuals in connection with the acquisition of the shares in petitioner. Surely this is not an ordinary and necessary expense of carrying on petitioner's trade or business. Except for the close relationship of the parties, it seems hardly conceivable that such an agreement would ever have been entered into. It would have been in any circumstance an unusual thing for a company owning the trade-marks and patents to pay royalties to some other company for their use rather than to be receiving royalties.
If the payment of these royalties be regarded as a further consideration for the agreement to refrain from pushing the claims against New York Eskimo Pie and the benefit to be derived from securing a licensee in the metropolitan area, the answer we have reached with reference to the deductibility of the interest is equally applicable here.
On both points the determination is affirmed.
Decision will be entered under Rule 50.