Docket No. 110072.
Lucien H. Boggs, Esq., for the petitioner. J. Marvin Kelley, Esq., for the respondent.
Petitioner, owner of rights under certain patents, made a contract by which a certain corporation agreed to pay royalties to the petitioner. Later, petitioner made a contract to sell 30 percent of its stock for $30,000, payable over a period of four years, with a provision that there should be credited on the $30,000, 30 percent of any royalties received by petitioner. This contract was made with the parent of the corporation which agreed to pay royalties. Thereafter, the parent corporation dissolved the other and took over the royalty contract by assignment, with provision for assumption of duty of paying royalties; and the royalties were, when payable, credited against the $30,000 due until the whole amount was, by application of royalties and cash, discharged. The contract with the parent corporation had provided that petitioner's receipts thereunder, except as required to redeem certain stock, pay indebtedness, and for retention as capital, should be distributed to petitioner's stockholders. Held, the royalties applied upon the $30,000 indebtedness constituted income taxable to the petitioner. Lucien H. Boggs, Esq., for the petitioner. J. Marvin Kelley, Esq., for the respondent.
This proceeding involves the redetermination of the following deficiencies in income tax:
+-------------+ ¦1935¦$148.67 ¦ +----+--------¦ ¦1936¦475.12 ¦ +----+--------¦ ¦1937¦385.55 ¦ +----+--------¦ ¦1938¦48.49 ¦ +-------------+
The only question at issue is whether, as determined by the Commissioner the entire amounts of certain royalty payments received by the petitioner during the taxable years constituted taxable income, or whether, as contended by the petitioner, only 70 percent of the amounts received are taxable.
FINDINGS OF FACT.
The petitioner is a corporation organized and existing under the laws of the State of Florida, having its principal office at 1001 Bisbee Building, Jacksonville, Florida. It filed its 1935 income and excess profits tax return with the collector for the district of Florida.
Since the time of its incorporation the petitioner has held certain patents and applications for patents on inventions of McGarvey Cline, its president and principal stockholder. Included among them in 1932 were applications numbered 443,616 and 539,585 covering inventions for treating oleo-resins so as to make them available for shipment in liquid form. On August 3, 1932, the petitioner and Cline entered into a contract with the Glidden Co., an Ohio corporation hereinafter referred to as Glidden, under the terms of which Glidden agreed to cause the incorporation of Nelio-Resin Corporation, hereinafter referred to as Glidden, under the terms of which Glidden agreed to cause the incorporation of Nelio-Resin Corporation, hereinafter referred to as Nelio, to operate under the two patent applications and any letters patent subsequently issued thereunder. The contract provided that Nelio should have a capital of 11,000 shares of common stock of the par value of $10 a share, of which 10,000 were to be issued to Glidden in exchange for cash and securities of the value of $100,000, and 1,000 were to be issued to the petitioner in consideration of the subsequent execution of a contract by the petitioner and Cline with Nelio to provide, in so far as is here material, as follows:
That petitioner grant to Nelio an exclusive license for a period of two years from August 3, 1932, to operate, manufacture and sell under the application and patents;
That Nelio have the option to extend the license for the full term of the letters patent upon agreement to pay royalties of $1.20 per ton on all products produced thereunder during the extended period;
That at any time after the expiration of five years from August 3, 1932, Nelio have the option to purchase the patents at a price to be computed by capitalizing average annual royalties, the price in no event to be less than an amount equaling $30,000 multiplied by the number of years of the term of the first patent issued them remaining unexpired; and
That additional applications and patents issued dealing with the same subject matter be subject to the agreement.
Other material provisions of the agreement of August 3, 1932, were to the effect that, in the event Nelio should fail to exercise its option to extend the license beyond the initial two-year period, then Glidden should purchase petitioner's 1,000 shares of Nelio stock at the price of $10 a share; that the petitioner would not sell its holdings in Nelio to any person without having first given the opportunity to Glidden to purchase the shares at book value or at $10 a share, whichever be the higher; that Nelio employ Cline for a period of two years as technical director of operations under the patents; in the event sufficient raw materials be unobtainable at prices enabling Nelio to make a net profit of 10 percent on operations, that Glidden have the right to terminate the contract and also the license agreement to be executed, the petitioner thereupon to transfer its Nelio stock to Glidden at $10 a share.
After the execution of the contract of August 3, 1932, Glidden procured the incorporation of Nelio and paid in to it $100,000 in cash and property. The petitioner received the 1,000 shares of Nelio stock and Cline entered its employ as technical director, all in accordance with their agreement. On January 12, 1933, a license agreement was executed by the petitioner, Cline, and Nelio, embodying the terms and agreements for which provision had been made in the contract with Glidden. It became apparent from experimental operations that operation under the patents could be made commercially profitable, but that considerably more than the original capital of $100,000 would be required for plant enlargement and working capital. Cline entered into negotiations with Glidden and Nelio in order to induce them or either of them to make additional investments. These negotiations culminated in the execution of a contract on February 20, 1934, between the petitioner and Glidden. By its terms the petitioner agreed to sell and Glidden agreed to purchase 500 shares of class B common stock of Wood Chemical Products Co., the petitioner's 1,000 shares of Nelio stock, and 273 shares of class A and 273 shares of Class B of the petitioner's common stock for the total price of $50,000, payable $20,000 for the Wood Chemical Products Co. stock and the Nelio stock, delivery and payment to be made forthwith, and $30,000 for the petitioner's stock, to be issued and paid for as follows: The petitioner to deliver the requisite number of certificates to an escrow agent, and Glidden to make payments of not less than $3,600 on or before January 17 in each of the years 1935, 1936, and 1937, and the balance on or before January 17, 1938. The petitioner agreed to redeem all its outstanding preferred stock promptly upon payment by Glidden of the $20,000. Further provisions were as follows:
4. (a) Process (the petitioner) entered into a certain license agreement with Nelio-Resin Corporation, a Delaware corporation, dated January 12, 1933, under the terms and conditions of which (if the option there given be exercised by Nelio-Resin Corporation) certain royalties are provided to be paid to Process at the times and in the amounts particularly specified in said license agreement. Process hereby agrees that so long as Glidden shall not be in default hereunder and Nelio-Resin Corporation shall not be in in default under said license agreement in the amounts and at the times therein specified, that, upon such payment of such royalties being made, and without further payment to itself or to the escrow agent, Process will execute and deliver to Glidden its certificate, certifying to said escrow agent that Glidden is entitled to credit on account of the purchase price of said stock to an amount equivalent to 30% of the royalty payment then made. At the option of Glidden it may call for and receive two or more credit certificates aggregating the total amount of credit to which it is then entitled, in such denominations as it may specify.
(b) Stock Certificates surrendered to Glidden in whole or in part on the basis of royalty payments hereunder shall not be entitled to participate in any dividend which may be declared by Process out of the 70% of such royalty payment not so applied to the payment of stock.
5. Glidden agrees to forthwith cause to be assigned, transferred and delivered to Process 250 shares of Class B common stock of Wood Chemical Products Company, an Ohio corporation, and Process, upon the delivery to it of such stock, shall assign, transfer and deliver to Adrian D. Joyce of Cleveland, Ohio, 91 shares of Class A and 91 shares of Class B of the common stock of Process.
6. All the moneys and stock received by Process under this agreement (except such portion of said moneys as shall be required for the purpose of redeeming said issued and outstanding preferred stock, and for the purpose of paying the present indebtedness of Process, and such portion as Process may elect to retain in its treasury as operating capital) shall be paid and distributed by Process to the holders of its common stock of record on February 1, 1934, ratably and in proportion to stock held by them.
7. The certificates evidencing the stock of Process herein agreed to be sold to Glidden and deposited with said Bank for delivery under the terms hereof, and those herein agreed to be transferred to said Joyce, shall bear appropriate legend reciting that the rights of the holder of such certificates are subject to the terms of this agreement.
8. Process represents that, excluding the shares of its stock herein agreed to be sold to Glidden and the shares agreed to be transferred and delivered to said Joyce, it has issued and outstanding a total of 546 shares each of Classes A and B common stock, and that it holds and owns as treasury stock 4090 shares of Class A and 4090 shares of Class B common stock. Process agrees that during the life of this agreement and so long only as Glidden shall not be in default thereunder, Process will not dispose of or sell any further shares of its common stock without the consent of Glidden.
9. No share of the stock of Process herein agreed to be sold to Glidden shall have any voting right or right to participate in any dividends that may be declared or paid by Process until Glidden shall have become entitled to delivery thereof under the terms of the escrow agreement hereto attached. Nothing in this paragraph contained shall be construed as altering or changing the provisions of paragraph 4(b) above.
10. Upon full performance of this agreement by Glidden, the stock of Process acquired thereby it shall be relieved of the legend specified in paragraph 7 hereof, and at the option of Glidden, new certificates free of such legend may be issued therefor.
Prior to the execution of the foregoing contract of February 20, 1934, the petitioner had received no return from the patents. Cline and the other stockholders were anxious that operations on a large scale be begun. They regarded the conditions imposed by Glidden, that the 1,000 shares of Nelio stock be sold to it and that 30 percent of all royalty payments be credited on account of the purchase price of the petitioner's stock, as essential concessions for them to make in order to procure the investment of additional capital by Glidden. Certificates for the number of shares of petitioner's stock to be acquired by Glidden were issued and placed in escrow, in accordance with the agreement. The escrow agent was directed to deliver certificates to Glidden from time to time in numbers which bore substantially the proportion to the whole number of shares as the amounts then paid or credited bore to the entire price of $30,000. The shares so placed in escrow comprised 30 percent of the total number of the petitioner's shares then issued and outstanding. In the fall of 1934 Nelio exercised its option to extend the license for the full term of the patents. Thereafter the investment in plant for production of the product was increased to the point where, by January of 1943, it amounted to about $500,000. At the same time the amount of working capital employed ranged from $1,000,000 to $1,500,000.
Glidden completed its agreement for the purchase of petitioner's stock in January of 1938. At that time the cash payments, together with the credits of 30 percent of royalty payments received by the petitioner, equaled $30,000. During the taxable years, until Glidden became entitled to receive the last of petitioner's stock in January 1938, 30 percent of the amounts received by the petitioner as royalties was as follows:
+----------------+ ¦1935 ¦$3,585.67 ¦ +-----+----------¦ ¦1936 ¦3,842.06 ¦ +-----+----------¦ ¦1937 ¦3,505.02 ¦ +-----+----------¦ ¦1938 ¦321.34 ¦ +-----+----------¦ ¦ ¦ ¦ +-----+----------¦ ¦Total¦11,254.09 ¦ +----------------+
Those amounts were credited, as received, on the purchase price of the stock. They were never taken up on the petitioner's books nor reported on its returns as income, but were immediately distributed to stockholders of record on February 1, 1934, ratably in proportion to their respective holdings on that date. Neither Glidden nor others who acquired stock subsequent to February 1, 1934, participated in the distributions. The remaining amounts of the royalty payments were entered on the books and reported on petitioner's returns as income. Dividends paid therefrom were paid to all stockholders of record.
On January 20, 1936, Glidden notified the petitioner that it had decided to dissolve Nelio and to procure the assignment to itself of the license agreement. The petitioner consented to the assignment upon the condition that Glidden assume Nelio's obligations. On January 30, 1936, Glidden agreed to do so, and since that time has operated as licensee. The respondent determined that the full amounts of royalties paid to the petitioner at first by Nelio and thereafter by Glidden constituted taxable income of the petitioner, and adjusted reported net income accordingly. Other adjustments are not in issue.
In January 1933 the petitioner granted to Nelio-Resin Corporation an exclusive license to operate under certain patents for a term of two years from August 1932, in consideration of the issuance by Nelio to the petitioner of 1,000 shares of its total authorized capital stock of 11,000 shares. Nelio received also an option to extend the license for the full term of the patents, subject to the obligation to pay royalties of $1.20 a ton on all products which it produced during the extended period. In February 1934 the Glidden Co., the owner of the remaining 10,000 shares of Nelio stock, as a condition for increasing its investment in that corporation, required the petitioner among other things to sell its holdings in Nelio to Glidden, to redeem its own preferred stock, and to agree to issue to Glidden for $30,000 sufficient of petitioner's common stock to constitute Glidden the owner of 30 percent of all outstanding stock. A contract including the above terms was executed on February 20, 1934. The purchase price was to be paid by Glidden over a period of about four years, during which time the petitioner agreed to credit 30 percent of any royalties received by it on the unpaid balance of purchase price. The contract contained the following provision:
6. All moneys and stock received by Process under this agreement (except such portion of said moneys as shall be required for the purpose of redeeming said issued and outstanding preferred stock, and for the purpose of paying the present indebtedness of Process, and such portion as Process may elect to retain in its treasury as operating capital) shall be paid and distributed by Process to the holders of its common stock of record on February 1, 1934, ratably and in proportion to stock held by them.
In the fall of 1934 Nelio exercised its option to extend its license for the remainder of the term of the patents. In January 1936 Glidden dissolved Nelio, took over its assets, including the license contract, a and thereafter itself operated as licensee. Until January 21, 1938, when Glidden completed the payments for petitioner's stock, the petitioner, in accordance with its agreement, credited 30 percent of all royalties received by it on the unpaid balance of the purchase price, such credits aggregating about $11,250. The balance of the agreed price was paid in cash. The portions of the royalties so credited to Glidden were not entered by the petitioner on its books nor reported on its returns as income, but were immediately distributed to stockholders of record on February 1, 1934, in proportion to their respective holdings.
The question for decision is whether the respondent correctly determined that royalties constituted taxable income in their entirety, or whether the petitioner properly excluded the 30 percent of each payment credited to Glidden and distributed to stockholders. In our opinion, the respondent's determination must be sustained. There can be no doubt that as a general rule royalties received in consideration of the grant of a license to operate under or use a patent constitute taxable income. Estate of Ernest Gustav Hoffman, 8 B.T.A. 1272, 1274, and cases there cited; Rafael Sabatini, 32 B.T.A. 705, 711; modified, 98 Fed.(2d) 753. Our only inquiry is whether any of the circumstances present in this case operate to take it out of that rule. The petitioner contends that the execution and performance of the contract of February 1934 with Glidden have that effect. We think otherwise. It is true that prior to the execution of the contract with Glidden no income had been realized, and it may be assumed for purposes of argument that, had the petitioner refused to accede to the conditions imposed by Glidden, the latter would not have taken steps to make operations profitable, and therefore that no income would have been realized. Thus, the petitioner's reasons for entering into the contract are apparent, and under the circumstances the fact that it did execute and perform it would constitute consideration sufficient to support the promise by Glidden to increase its investment in Nelio. But the question of the legal effect of the contract upon income tax depends upon the contract itself, rather than upon circumstances motivating its execution. Here the petitioner was under obligation to credit 30 percent of all royalties to Glidden. It is difficult to dee upon what theory that obligation may be said to deprive the amounts in question of their character as royalties and as income. Standing alone, it does not even amount to an assignment of income. Its only effect was to reduce the amount of money the petitioner received in exchange for its stock, and to reduce Glidden's cost correspondingly. Cf. Indian Creek Coal & Coke Co., 23 B.T.A. 95.
According to the petitioner it was under further obligation to distribute the amounts in question to the persons who were its stockholders of record on February 1, 1934. The contract, however, required distribution only of moneys received under ‘this agreement,‘ except such portions as might be required for redemption of preferred stock, for payment of indebtedness, or as petitioner might elect to retain for operating capital. The royalties were not received by the petitioner under ‘this agreement,‘ but under the preexisting license contract with Nelio. Moreover, even if the parties intended that royalties be included, and if the contract permits such a construction, there is still no evidence to show the amounts required for the redemption of preferred stock, for payment of indebtedness, or what portions the petitioner might have elected to retain in its treasury; therefore the amount distributable is unascertainable. Thus it does not appear that the contract imposed any obligation upon the petitioner to make distribution of the amounts in question, i.e., the royalties, to its stockholders. However, even under the petitioner's theory that it was bound to distribute, the most that can be said is that the provision in question effected an assignment of income, and it is well established that such an assignment, however binding, does not operate to prevent taxation of the income to the assignor. Lucas v. Earl, 281 U.S. 111; Helvering v. Horst, 311 U.S. 112; Helvering v. Eubank, 311 U.S. 122; Harrison v. Schaffner, 312 U.S. 579. It is true that at the time of the ‘assignment‘ the petitioner had no vested right to future income, nor even any certainty that it would subsequently become entitled to receive income, but in this respect the situation is not different from that in Lucas v. Earl, supra, where in 1901 the taxpayer by contract agreed that all earnings and property which he might receive at any future time would be received and owned by him as a joint tenant with his wife. The Supreme Court held that the whole of the salary and attorney fees earned by the taxpayer in 1920 and 1921 were taxable to him. The determinative factor in this case is that the property constituting at first the potential and later the actual source of the income remained at all times in the petitioner's ownership. Whether the patents themselves or the license agreement with Nelio be considered the income-producing property is immaterial, since the petitioner owned both, and never purported to dispose of any interest in either. We have held that earnings of a corporation, though never paid to it, but paid to its stockholders, nevertheless constitute income to such corporation. Gold & Stock Telegraph Co., 26 B.T.A. 914; affd., 83 Fed.(2d) 465; certiorari denied, 299 U.S. 564.
The petitioner contends that 30 percent of the royalties were distributed to stockholders as compensation for the diminution of their proportionate interests in the equity of the corporation caused by the issuance of stock to Glidden. However true, that does not alter the fact that the patents and the license contract remained the petitioner's property nor the consequent conclusion that the income therefrom is taxable to it. Cf. Gray Processes Corporation, 43 B.T.A. 624; affd., 122 Fed.(2d) 1021; Simms Petroleum Co., 28 B.T.A. 1107; affd., 74 Fed.(2d) 561; W. L. Shore, 26 B.T.A. 389. Even if the contract of February 20, 1934, could be considered as in substance a contract by the petitioner's stockholders individually to sell 30 percent of their respective holdings, an agreement that they receive a like percentage of all royalties would not have effected a transfer to them of any interest in the patents or the license contract. See Helvering v. O'Donnell, 303 U.S. 370. The petitioner held one contract with Nelio under which it would become entitled to receive royalties taxable to it if Nelio should elect to extend its license. It then entered into another contract with Glidden by which it obligated itself to make certain application of the royalties it would receive from Nelio if the license should be extended. The two separate contracts were with two separate entities. The character of the rights enjoyed by the petitioner under the one was not affected by the contractual obligations imposed upon it by the other; and the same would be true if we consider the stockholders as agreeing to sell stock and receive royalties. The character of the royalties would not be changed.
The petitioner contends in the alternative that the amounts in question were either paid on the purchase price for the stock sold to Glidden, or constituted payments by the petitioner for the development of its patents, and in either event the moneys received were capital items. The facts disclose no justification for upholding either of those contentions. Even if the separate corporate entities of Glidden and Nelio were to be disregarded, the income character of the royalties would not be altered by reason of the fact that the petitioner bound itself to credit a portion of them on the purchase price of the stock. As has been pointed out, the most that may be said is that such an allocation amounted only to an adjustment of the purchase price. We find no basis for the argument that the amounts in question were capital expenditures made for the development of the patents. The only payments made by the petitioner were in the form of distributions to its stockholders, having no regard to patent development.
The petitioner's last contention has to do only with royalties paid subsequent to the time when Glidden acquired Nelio's interest in the license contract, assuming the obligations and agreeing to be responsible for all the provisions thereof. Thirty percent of the royalties paid after that time, it is urged, can not be income because the same legal entity was both paying the moneys and receiving that percentage as a credit against the purchase price of the stock. It must be remembered, however, that Glidden was obligated to the petitioner under two separate contracts, the one requiring it to pay royalties and the other requiring it to pay for certain stock. The effect of the petitioner's contention is that the stock purchase contract effected a modification or a partial abrogation of the license contract, just as if a new agreement had been entered into between it and Glidden providing that thereafter royalties should be paid at the rate of $.84 a ton on all production, or 70 percent of the $1.20 per ton theretofore agreed to be paid, and that for each such royalty payment there should be a contemporaneous payment of $0.36 not as royalty but on account of the purchase price of petitioner's stock, until January 17, 1938, or until such earlier date as the aggregate of the amounts so applied upon the price of the stock plus other cash payments therefor should equal $30,000; and that thereafter the royalty payments be again increased to $1.20 a ton. If the license contract had been modified so to provide, the question whether such provision could affect the character of the payments as income would be presented. That was not done, however. On the contrary, that contract remained in full force in accordance with its terms. The old royalty contract with Nelio was carefully assigned to Glidden, which bound itself to its terms. That was the underlying and preexisting contract, the performance of which will not be completed until the terms of the letters patent have expired. The petitioner does not deny that the payments made thereunder constitute taxable income in their entirety, except for the relatively short period ending in January 1938. Thereafter, on petitioner's theory they would be royalties, as the license contract calls them. We hold that the stock purchase contract did not effect a modification of the license contract, and that the income character of the payments made under the latter was not altered because of the application which petitioner agreed to make and did make of them. It follows that the full amounts paid under the license contract constituted taxable income.
Decision will be entered for the respondent.