Hershey Mfg. Co. v. Commissioner

HERSHEY MANUFACTURING CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Hershey Mfg. Co. v. Commissioner

Docket Nos. 28862, 32108.

United States Board of Tax Appeals

14 B.T.A. 867; 1928 BTA LEXIS 2898;

December 20, 1928, Promulgated

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1. A patent application is an assignable property right capable of being valued as evidence of the value of stock of a corporation for which it was exchanged.

2. Costs of development incurred subsequent to the filing of the application for a patent must be shown to add to the capital value of that patent before they can be added to the depreciable base of such patent.

3. A patent application is not a depreciable asset. When a patent issues, however, depreciation may be taken over the life of the patent.

4. Experimental expenses should be charged to capital or expense depending upon the nature of the expenditure. In the absence of evidence as to the nature of the experiment the deduction of such expenses can not be allowed.

5. Cost of organizing a corporation may not be recovered by exhaustion deductions.

Geo. E. H. Goodner, Esq., for the petitioner.

Harry LeRoy Jones, Esq., for the respondent.

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SIEFKIN

These proceedings result from deficiencies asserted in income taxes for the years 1922 and 1923, in the respective amounts of $1,727.26 and $524.55. The two cases were consolidated for hearing and decision. The errors alleged and pressed were:

(1) Inadequate depreciation allowance on patents (involving a question of basic cost of patent application acquired for stock);

(2) Disallowance of deduction amortizing corporate organization expenses over the period of corporate life; and

(3) Disallowance of cost of experimental work as deduction.

FINDINGS OF FACT.

Petitioner is, and during the years in controversy was, a Colorado corporation with principal offices at Denver. It was incorporated on October 18, 1919, to take over a patent application on an automobile lock and to engage in marketing that device as set forth in greater detail below.

About March of 1919, O. S. Hershey, a machinist and tool maker who had been employed in the experimental departments of a number of concerns, became impressed with the need of a theft-proof automobile lock. After conceiving the idea incorporated in the lock patented, he consulted with his brother, J. C. Hershey, resigned his position and went to work upon the patterns preparing to make the first model. Within the course of several weeks after the formulation of the design in his mind, he had the matter in the hands of a patent attorney. The design was worked out without reference to any existing locks.

The invention was a lock designed to be secured to the steering column of an automobile within convenient reach of the driver. The basic principle of the lock was a bolt which moved inwardly into a hole in the steering post to prevent that post from rotating when the car was locked. The bolt was actuated by a key working in an ordinary cylinder lock. If the hole in the post was not turned directly toward the bolt, it could not advance, but the key was actuated regardless of the position of the steering post so that, upon subsequent attempt to steer the car, the bolt would engage the steering post when the hole was first turned directly toward the bolt, making the post rigid and making it impossible to steer the car. This latter feature was thoroughly covered by the patent application. The only way a car equipped with such device could be stolen was by use of some apparatus raising the front wheels off the ground. The lock could not be removed from the steering wheel while in the locked position for, when in that position, all of the screws by which it was attached, were concealed.

There were several automobile locks on the market at the time. Aside from a steering wheel lock, which is no longer on the market and worked on a different principle than the invention in question, the most effective prior locks operated on the transmission. They locked the gears in the neutral position. In two respects the Hershey lock represented an improvement over those. In the first place the gear locks were so located as to require the driver to change position to lock his car, which caused many to neglect to do so. More important still, a car with a transmission lock could be stolen by means of towing.

Under an agreement between the inventor and his brother, the latter was to have a half interest in whatever developed in return for his supplying needed funds. The brother interested three others George L. Nye, George L. Felt, and Rens E. Schirmer. Nye was a prominent attorney of Denver who afterward was active in the petitioner's organization and gave counsel on general legal matters. Felt and Schirmer were prominent mining engineers of that locality. Felt later dropped out and his place was taken by Joe Terry, a wealthy mine owner, who became general manager. He also asked for the exclusive sales right in part of the United States. Schirmer became interested at his own request. The half interest of J. C. Hershey was divided equally among these four giving each a one-eighth interest, which interest continued until petitioner was organized. The preliminary expense connected with the invention amounted to $2,000. Credit for an additional $5,000 was given to these four individuals in investigating the marketability of the device to determine whether additional investment was justified. No further effort was made to raise additional capital prior to incorporation.

The reaction to the lock device was encouraging from the start. Several models were made experimenting with its appearance. It was then decided to build 300 locks as an initial step. Of this number about 200 were manufactured by the interested parties at a cost of about $6 each. All but twelve, which were given away, were sold, put on cars and used. They proved satisfactory and no complaints were made concerning them. The Denver representative of the Cadillac Motor Car Co. purchased 25 to put on cars he sold to customers. Locks had not become standard equipment on any cars at that time and the only approach to automobile manufacturers was by building up a demand through the accessory market.

No other locks were manufactured prior to incorporation. Salesmen using the models, however, took orders for some 600 locks. The list price was fixed at $12 per lock with 50 per cent off to jobbers. From the cost of manufacturing those already made and from bids obtained from manufacturers, it was estimated that the locks could be made at a cost of $3.50 each. Cost of selling, commissions, advertising, and traveling expenses were estimated at $1.50 per lock, leaving an estimated profit of $1 per lock. Consultation with advertising firms and jobbers who desired selling rights convinced the parties interested that they had a product of merit which would be in great demand. The Underwriters Laboratories (which tested locks for the National Automobile Underwriters) conference approved the lock as entitling owners whose cars were equipped with the device to the 15 per cent reduction in insurance rates allowed for adequate locking equipment.

Automobile production was on the increase at this time. Some 2,000,000 new cars were being produced annually. The advertiser consulted advised that no difficulty ought to be encountered in selling 1,000,000 locks in 10 years. On the basis of the foregoing facts the several associates interested in the invention estimated they could sell 5 per cent of the anticipated motor car production which resulted in an estimate of 1,000,000 sales in 10 years at a profit of $1 each. They expected that such a number of sales would be attained only be continuously increasing sales from year to year. They concluded their rights in the patent application were worth $250,000 when petitioner corporation was organized in October of 1919.

Petitioner's authorized capital stock of $500,000, divided into 8,000 shares of common and 2,000 shares of preferred, each share having a par value of $50, was issued to the incorporators for their interests in the patent application and any refinements pertaining thereto developed or to be developed by the inventor. Half of such stock, including all the preferred, was returned to the petitioner as treasury stock to be sold to raise needed working capital. Sales were made only to the incorporators, close friends and office associates. The preferred stock was sold at par and the common stock issued therewith as bonus stock. The rate of bonus stock issued decreased in the later sales. Subsequently changes were made in capitalization giving petitioner authorized preferred stock having a $200,000 par value. The sale of preferred stock to date amounts to $110,000 par value. The object of providing working capital having been attained, no attempt was made to sell additional stock. In recent years all preferred stock was made convertible into common stock at the option of the holder and all but 58 shares have been so converted.

The first quantity order for 25,000 locks came in July, 1920, from the Simplex Corporation of Chicago, an accessory firm, after that firm, during the course of that month, had investigated the lock, found it satisfactory, and took over the distribution. The net profit realized upon this order amounted to $1.75 per lock. This firm continued to handle distribution for three or four years until petitioner decided to abandon the accessory field. During that time it purchased approximately $550,000 worth of locks from petitioner. It considered the lock far superior to any other lock of any type and attributed its success to its merits.

By 1920 petitioner began approaching automobile manufacturers to adopt the lock as built-in standard equipment. The Elgin Motor Car Co. was the first to adopt the lock, in 1921. The Rickenbacker Motor Car Co. followed in 1923, and the Studebaker Co. in 1924. The first two companies have since gone out of business. The automobiles on which the lock was standard equipment at the time of hearing were the Studebaker, Graham-Paige, Buick, Lincoln, Chevrolet and Jordan. The Ford Motor Car Co. negotiated for a license to manufacture under the patent for use on the Ford car but failed, as the granting of such license was contrary to petitioner's policy.

During the 8 1/2 years following incorporation petitioner sold approximately 2,500,000 locks. The estimated present annual output is 1,000,000. At first petitioner had the lock manufactured by others. Later it built a factory and now makes them in its own plant.

The profits and losses of the petitioner for the years 1919 to 1924, inclusive, were as follows:

	Profit	Loss
1919		$1,426.88
1920		6,290.73
1921	$14,575.30
1922	29,548.62
1923	6,196.37
1924		31,236.71

The dividends paid by petitioner to July 1, 1925, were as follows:

1920	$281.39
1921	2,522.13
1922	1,492.00
1923	$1,492.00
1924	1,499.96
1925, to July 1	2,519.63

The principle patented has been used throughout petitioner's life. Refinements have to do largely with the outside appearance. The lock remained essentially the same, though adjustments have been made to adapt the lock to uses on the various makes of automobiles. The patent, No. 1,417,603, was issued to the petitioner corporation on May 30, 1922, pursuant to the application filed by the inventor and assignment made by him to petitioner when petitioner was organized. The two years delay in issuing the patent was a reasonable time to complete the proceedings. Some of the claims made in the application had been allowed by the patent office before petitioner acquired the rights thereto. Those rejected were denied on merely formal grounds. The application was investigated prior to the time petitioner received it in exchange for stock. The Simplex Corporation also caused an investigation to be made before entering into the contract of distribution in July, 1920. None of these searches disclosed any infringement of other patents. Nor has petitioner or others ever had other than minor threats concerning alleged infringements, none of which resulted in litigation.

Petitioner holds some 17 other patents acquired by purchase, none of which are in use. They were purchased as a matter of good business to forestall possible litigation and to prevent use by competitors. None of these involve the same principle covered by the Hershey patent.

No effort has ever been made to build up a trade name or trademark around the patented device. While in the accessory market, orders were received for the "Hershey Lock" and the "Theft Proof Lock." Those sold to manufacturers were not separately identified but were sold as the car maker's own product.

The value of the rights to the patent application paid in for stock was $75,000 on the date the exchange was effected, and, as this was the sole corporate asset at that time, the stock issued therefore had a value equal to the worth of such asset.

Between the time petitioner acquired the rights to the patent application and the date the patent was issued, petitioner expended $4,666.77 in experiments relating to such patent. This experimental cost was capitalized. Petitioner first claimed depreciation on account of the Hershey patent in 1922 in the amount of $8,578.43, of which only $61.62 was allowed. In 1923, the depreciation deduction claimed was $14,705.88, all of which was disallowed.

Experimental costs pertaining to the patent during the year 1923, amounting to $329.50, were claimed and disallowed as an expense deduction for that year.

The cost of organizing petitioner corporation was $1,271.71. Its charter was for a period of 20 years. Petitioner's claimed deduction in each year in question, in the amount of $127, by way of amortization of such organization cost was disallowed. In now claims one-twentieth of such cost as an allowable deduction for each of the years in question.

OPINION.

SIEFKIN: The principal question herein presented for our consideration is the basis for computing the depreciation or exhaustion allowance on the Hershey patent for the years in question. The first step in the acquisition of this patent by petitioner consisted of an exchange of 4,000 shares of its common stock issued at the time of incorporation to the inventor, his brother and three associates, for their rights in an application for patent then pending. It is the value of the stock at the time exchanged that is the primary object of our search. Kennedy Construction Co.,4 B.T.A. 276">4 B.T.A. 276. We are concerned with the value, if any, of the patent application only as it may be reflected in, and constitute evidence of the value of the stock.

No stock was offered to others than those interested in the patent application or their close friends. Under such circumstances stock sales, though the evidence concerning them were more complete, would not, standing alone, be a dependable index to the value of the stock. The record consists principally of evidence pertaining to facts relating to the patent application and its value. We have repeatedly held that the value of corporate assets evidences the value of the stock. Respondent, however, earnestly urges that an application for a patent is not an assignable right which may be definitely valued and asks reconsideration of prior decisions by this Board holding the contrary. See Individual Towel & Cabinet Service Co.,5 B.T.A. 158">5 B.T.A. 158; Commercial Truck Co. of America,5 B.T.A. 602">5 B.T.A. 602; Union Paper Co.,9 B.T.A. 1010">9 B.T.A. 1010; Hartford-Fairmont Co.,12 B.T.A. 98">12 B.T.A. 98; and International Banding Machine Co.,12 B.T.A. 1062">12 B.T.A. 1062.

As this contention attacks the means principally relied upon by petitioner to show the value of the stock, it must be disposed of as a preliminary to any discussion of the value established by such evidence.

Respondent cites Marsh v. Nichols, Shepard & Co.,128 U.S. 605">128 U.S. 605, as authority for his proposition that there is no property right in a patent application. That case merely holds that there is no such right in a patent application as will ground a suit for infringement. While it is true the court in that case did say there was no property right until the patent issued, the import of such statement was limited to the matter in question by the addition of the clause "that is, no such right as the inventor can enforce." Furthermore, that decision quotes with approval from Gayler v. Wilder ,10 Howard 476">10 Howard 476, at page 491, in which the court said:

The inventor of a new and useful improvement certainly has no exclusive right to it, until he obtains a patent. This right is created by the patent, and no suit can be maintained by the inventor against any one for using it before the patent is issued. But the discoverer of a new and useful improvement is vested by law with an inchoate right to its exclusive use, which he may perfect and make absolute by proceeding in the manner which the law requires. Fitzgerald possessed this inchoate right at the time of the assignment. The discovery had been made, and the specification prepared to obtain a patent. And it appears by the language of the assignment, that it was intended to operate upon the perfect legal title which Fitzgerald then had a lawful right to obtain, as well as upon the imperfect and inchoate interest which he actually possessed. The assignment requests that the patent may issue to the assignee. And there would seem to be no sound reason for defeating the intention of the parties by restraining the assignment to the latter interest, and compelling them to execute another transfer, unless the act of Congress makes it necessary. The court thinks it does not. The act of 1836 declares that every patent shall be assignable, in law, and that the assignment must be in writing, and recorded within the time specified. But the thing to be assigned is not the mere parchment on which the grant is written. It is the monopoly which the grant confers; the right of property which it creates. And when the party has acquired an inchoate right to it, and the power to make that right perfect and absolute at his pleasure, the assignment of his whole interest, whether executed before or after the patent issued, is equally within the provisions of the act of Congress.

Cf. Keystone Type Foundry v. Fasteners Co.,263 Fed. 99, at page 100.

There is nothing in the Marsh case, supra, indicating any intention to overrule the principle established by the excerpt quoted. On the other hand the principles there enunciated have been followed in subsequent cases; see Montgomery, Income Tax Procedure, 1925. We must, therefore, reject the contention that there is no property right in a patent application. It is likewise apparent from the above quoted excerpt that such property right is assignable.

May such assignable property right be definitely valued? The case of Durham v. Seymour,161 U.S. 235">161 U.S. 235, is cited by respondent as authority for his negative assertion. In that case, which was an appeal from a decision of a lower court refusing a decree authorizing the Commissioner of Patents to issue a patent, the only question, so far as pertinent to this discussion, was whether the matter in dispute, i.e., whether or not a patent should issue, amounted to at least $5,000 so as to give the United States Supreme Court jurisdiction to consider the appeal under acts of Congress pertaining thereto. In answering the question considered in the negative, the court said in part:

The matter in dispute was not money, and the only remaining inquiry is whether it was a right capable of being ascertained in money and appearing to be of the requisite pecuniary value?

The answer to this inquiry requires the application of the settled and necessary principle that the matter in dispute is, * * * "the subject of the litigation - the matter for which the suit is brought," and that matter here was the issue of a patent, that is, an application to the courts below to hold the alleged invention patentable and authorize a patent to be issued.

After referring to the decision cited above to the effect that a patent application was an assignable property right, the court continues:

The right to apply for a patent was being availed of in this proceeding and the invention cannot be regarded for jurisdictional purposes as in itself property or a right of property having an actual value susceptible of estimation in money.

Whether the alleged invention were patentable or not was the question, and that question had no relation to its value in money. If the invention were not patentable, Durham had suffered no loss; if the invention were patentable, it was not material whether it had or had not a money value.

The bill, properly enough, does not allege that any sum of money was in dispute, although there are averments that the value of the invention is generally recognized, and that sundry persons are deriving large profits in making the device sought to be patented. Evidence of that kind, though not controlling, is sometimes introduced in suits on patents as indicative of invention in the production of new and beneficial results, but it is not relevant here, nor are the affidavits presented on the question of value if the patent were granted. The matter in dispute must have actual value, and that cannot be supplied by speculation on the possibility that, in a given case, an invention might be held patentable.

* * *

We are of opinion that the matter in dispute in this case was not capable of being valued in money, and that the appeal must be dismissed.

In our opinion, the language of the Supreme Court quoted above, when the question before the court is noted, does not go to the extent of holding that there is no property capable of valuation. No question of the value of the alleged right to obtain a patent had been raised in the courts below. Nor was any question of such value involved in the appeal. The sole reason for considering the point was to determine whether the record showed a minimum sum in controversy to give the court jurisdiction. The record did not only show no such amount but that the question presented had no relation to value. It was pointed out that a patent when issued may or may not have a value. That being true, the court could only speculate as to the value of alleged right. That the court refused to do. In other words the court saw no justification for assuming that the patent application in question had a value. That is very different from saying that such value is not susceptible of proof as evidence of value of stock exchanged therefor. Considering the traditional policy of the Supreme Court of deciding only the issue before it, we do not consider the language authority for the respondent's broad assertion that an application for a patent can not be definitely valued.

Nor is the contention persuasive upon its merits. While such value may be difficult of proof, the same may be said of other intangible property values which the courts are constantly determining from evidence. In Robb's Patent Essentials, 1922, page 258, it is said:

While it is very common to-day for assignments of inventions to be made prior to issue of the patent therefor, strictly speaking, an invention is not an assignable monopoly until its ownership is fixed. The only method of establishing a prima facie ownership is by obtaining a patent.

Therefore, it is to be understood that the risk is upon the purchaser who buys an invention while it is resting under an applicat on for patent. Proper investigations will enable the determination of the allowability of a patent, and the probable scope thereof, with a fair degree of safety. When such investigations are made there is a suitable basis for both inventor and purchaser to come to terms for the purpose of transfer of the monopoly.

Undoubtedly, petitioner purchased the application rights at its risk. But such risk is not peculiar to patent rights. Questionable titles and supposed causes of action are often the subject matter of valuation, purchase and sale. Doubts as to title or the extent of ultimate rights are matters to be considered in any attempt at appraising propery rights to which they pertain. They influence but do not preclude valuation. We must, accordingly, reject petitioner's preliminary contention that the patent application was not an assignable property right which could be definitely valued.

Respondent claims that the evidence of record is subject to the same infirmity as was found by the Board in Commercial Truck Co., supra, in regard to which we stated:

The evidence submitted consisted of the testimony of engineers familiar with the petitioner's invention. Their opinions of value were upon the hypothesis that petitioner owned a patent on March 1, 1913, and were based upon the estimated royalties from the patented articles. This evidence is not sufficient to enable the Board to determine what value, if any, should be ascribed to the application for letters patent, which application was all that the petitioner owned on March 1, 1913. (Italics supplied.)

It is true, as respondent points out, that some of the questions framed by petitioner's counsel purport to refer to a patent rather than a patent application. But it is also apparent that the witnesses, including those who gave opinion testimony, were familiar with the history of petitioner and knew that what petitioner received was a patent application. The two terms were used interchangeably throughout the record. If the confusion in terminology led to confusion in thought, the respondent's point would be well taken. A careful search of the record, however, leaves no doubt in our mind that there was no such confusion as to the subject matter of testimony. It is clear that the evidence relates to that which petitioner actually received - a patent application.

None of the parties, including counsel for respondent, were misled. The record clearly distinguishes the case from such circumstances as are set forth in the excerpt quoted.

We come then to the question of determining the value of the stock issued for the patent application by reference to the value of the only corporate asset - the application. We are of the opinion that a substantial value in such asset has been proven. A substantial improvement over the prior art, and then existing prospects of a large market for the device at a good profit, are well established. The wide market has been substantiated by subsequent events, and the failure to realize the anticipated large profits may be due to many elements having no relation to the value of the patent application or the patent later issued. The evidence tending to show the claimed value of $250,000 is not inconsiderable. We have, however, discounted the claimed value to the $75,000 as found, in view of all the evidence.

Petitioner asserts that to this initial cost of the patent application there should be added the subsequent costs of experiment and development incurred to the date the patent was issued to determine the basis for depreciating such patent. Our belief is that before the expenditures can be either capitalized or charged as expense, their nature must be shown. If they can be compared to the cost of prosecuting the claim for a patent or cost incurred in defending title thereto once the patent issues, they can be said to relate directly to the patent property right. So far as appears here, however, the experimental cost subsequent to the acquisition of the application did not add to the capital value of the patent in question and should be excluded from its depreciation base.

This brings us to a consideration of the proper depreciation period over which the patent capital account may be exhausted. It is elementary that an asset which has no definite period of useful life is not the proper subject of exhaustion, as one of the essentials to measuring the deduction is unknown. The period covered by application pending is a variable factor. Furthermore, the date the patent issues marks the beginning of the asset in use in an enforceable right, as well as fixes its life. It follows that the inchoate right represented by a patent application matures into a depreciable asset beginning with the date the patent is issued and extending over the 17-year period covered thereby.

What has been said respecting experimental costs resolves the claim for a deduction for 1923 on account of such expenditures made in that year against the petitioner. It is claimed that such expenditures were development expenditures under the patent. We are without evidence from which the nature of the expenditures may be determined, and the denial of the deduction taken must be approved.

There remains the question whether costs of organization may be recovered by pro rata exhaustion deductions over the twenty-year period of corporate life. We have heretofore held that such cost can not be deducted as an expense item; Logan-Gregg Hardware Co.,2 B.T.A. 647">2 B.T.A. 647; First National Bank of St. Louis,3 B.T.A. 807">3 B.T.A. 807; Emerson Electric Manufacturing Co.,3 B.T.A. 932">3 B.T.A. 932; American Colortype Co.,10 B.T.A. 1276">10 B.T.A. 1276. It represents the expenditure for a corporate asset used or useful in its business.

In Corning Glass Works,9 B.T.A. 771">9 B.T.A. 771, we held that the amount paid to financial agents for services in selling stock could neither be amortized over the maximum life of the stock and thus (based upon the remaining life of the corporation) taken as a deduction, nor be taken as a deduction in a later year when the stock was retired.

Reasoning from that case, we see similar reasons here for denying any pro rata deduction even though it be admitted that the organization costs are capital items. It is a matter of common knowledge that corporate charters for a definite period are often renewed or materially changed during that period or are permitted to lapse before the term expires. Further, although we have found that the cost of organizing the petitioner corporation was $1,271.71, we are unable to find from the evidence that such amount was paid by the petitioner. There is a possibility, at least, that such amount was paid by the promoters, before the corporation came into existence. We are unable to say that the revenue acts contemplate a deduction for exhaustion in such a case.

Reviewed by the Board.

Judgment will be entered under Rule 50.

TRAMMELL and PHILLIPS dissent on the last point.