Tennessee Fibre Co. v. Commissioner

TENNESSEE FIBRE CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Tennessee Fibre Co. v. Commissioner Docket No. 10717. United States Board of Tax Appeals 15 B.T.A. 133; 1929 BTA LEXIS 2910; January 30, 1929, Promulgated *2910 1. March 1, 1913, value of a patent determined. 2. Petitioner is entitled to deduct normal exhaustion on its patent based upon the March 1, 1913, value as herein determined. 3. L. S. Ayers & Co.,1 B.T.A. 1135, followed. E. Barrett Prettyman, Esq., and Preston B. Kavanagh, Esq., for the petitioner. John D. Foley, Esq., for the respondent. MORRIS *133 This proceeding is for the redetermination of a deficiency in income and profits taxes of $33,338.81 for the year 1918. The particulars in which the respondent is alleged to have erred are: 1. Failure of the respondent to allow as a deduction in 1918 any allowance for the obsolescence, exhaustion, wear and tear or loss of *134 patents, processes, or other intangibles owned by the taxpayer and used in its business which became exhausted and obsolete and suffered an entire loss of value during the year 1918; and 2. The deduction by the respondent from invested capital for the year 1918 of income and profits taxes for the preceding year; and 3. The action of the respondent in computing a tentative tax for the year 1918, prorating such tax over the year, *2911 and deducting such tax for the period from January 1, 1918, to the date of certain dividends, in ascertaining the earnings available for such dividends, and as a result of such computation deducting a portion of said dividends from invested capial for the year 1918. FINDINGS OF FACT. The petitioner is a corporation, organized and incorporated under the laws of the State of Tennessee in or about the year 1893, which prior to its incorporation was a copartnership engaged in the manufacture of pulp from cotton. In the earlier years of its existence petitioner's product was sold as a raw cotton fiber for use in the manufacture of horse collars and low-grade paper, etc. William C. Johnson, general manager and treasurer of the petitioner, having invented a process for separating cotton fiber from cotton seed hulls and bleaching and purifying the resulting product, was granted Letters Patent No. 733969 on July 21, 1903, which shortly thereafter became the property of the petitioner and was owned by it during the years here under consideration. The specifications made a part of the said letters patent read: Be it known that I, WILLIAM C. JOHNSON, of Memphis, in the county of Shelby*2912 and State of Tennessee, have invented certain new and useful Improvements in Bleached Paper-Pulp from Cotton-Seed Hulls; and I do hereby declare the following to be a full, clear, and exact description of the invention, * * * * * * My object is to secure a quality of paper-pulp or bleached cotton fiber from seed-hulls which is superior to all other paper-pulps now on the market in purity, color, length of fiber, and in having properties that are peculiar to the cotton fiber alone. For this purpose I use the cheap and practically waste product of the cotton-seed-oil mills known as "cotton-seed hulls." * * * The handling of the cotton up to the process invented by Johnson is as follows: After the cotton is picked it is put through a ginning process which separates the lint and the seeds; the seeds, which have certain short fiber growing therein, not removed by the first ginning process, are sold to oil mills which put them through a reginning process, similar to the first ginning, which removes most of the remaining short fibers commonly known as linters. After these processes there are still some fibers adhering to the seed but which are *135 rendered much shorter by*2913 the treatment received. The seeds are then cracked, split open, and the kernels removed, leaving two products, the kernel of the seed and the hull of the seed, the fiber still adhering. Oil and seed meal are made from the kernel and the hulls were a waste product, great quantities of which were sold for cow feed at about $2 a ton, and great quantities were burned at the time petitioner was organized. By the process invented by Johnson the hulls were subjected to an attrition action, in suitable mills, for the purpose of breaking the hulls, having the effect of separating the hull particles as one product, and the resulting fiber product, which was rendered free from the bran or hull particles, was fluffy, and almost pure cotton cellulose. At first the petitioner attempted to sell the purified fiber to paper mills for use in the manufacture of high-grade papers, and, although it met with more or less success, the product was found to be unsuitable for the very best grades of paper because it contained dirt, and particles of hulls would appear in the paper. It was discovered, however, that the resulting product by the process above described produced a very absorbent cotton and*2914 by sending samples to powder mills the petitioner developed a trade in it for gun cotton and smokeless powder and thereafter its product was sold exclusively to munitions manufacturers for the manufacture of those explosives at a contract price of approximately 5 1/2 cents per pound. Prior to Johnson's process, E. I. du Pont de Nemours & Co., Inc., known as the du Pont Company, used high-grade linters as a gun cotton base which cost about 6 cents a pound as compared with the lower price charged for the petitioner's product. Upon the purchase of the petitioner's product the du Pont Company steeped it in sulphuric and nitric acids, the sulphuric acid acting merely as a means of keeping down the moisture, and nitric acid being the active agent converting the purified cotton into nitro cellulose. The acids were then drained out and it was washed thoroughly, then the product was pulped, dried, and made partly soluble in alcohol, and it was then pressed into convenient shapes and constituted what is commercially known as smokeless powder. When the du Pont Company used raw linters it was required to process them before they were ready for the action of the sulphuric and nitric acids*2915 in much the same way as the petitioner processed its fiber, making them chemically pure and bleaching them. That Company purchased about 75 per cent of the petitioner's product between 1903 and 1913 and the balance was sold to the Government Navy plant at Indian Head and to one or two independent powder manufacturers. Between 1903 and 1913 the petitioner had a monopoly on the manufacture of purified bleached cotton fiber from low-grade linters. *136 However, the patents hereinbelow described were registered in the United States Patent Office after 1900: Number Date granted Letters patent of - For - 683785 Oct. 1, 1901 Thomas Newsome Improvement in processes of manufacturing cellulose stock from cottonseed hulls and products thereof. 822883 June 5, 1906 James S. Cochran Improvement in cellulose. 930874 Aug. 10, 1909 Oscar Muller Improvement in cellulose substitutes. 1244131 Oct. 23, 1917 Atlanta Utility Works Improvement in methods of an apparatus for delinting cottonseed hulls. 1295078 Feb. 18, 1919 Frank W. Stockton Improvement in methods of purifying cottonseed hull fiber. *2916 In March, 1913, the petitioner was doing a profitable business, its management was regarded highly for its competency and efficiency, and the prospects for continued prosperity and for an increase in the volume of its business were exceedingly good. An examination was made of the petitioner's books and records in 1917 for the period 1909 to 1916, and in 1921 a further examination was made for the years 1917, 1918, 1919, and 1920 and the revenue agents made adjustments in the property accounts and depreciation reserves for each year from 1903 to 1916. The financial condition of the petitioner during the five years immediately preceding 1913 is revealed by the following balance sheets, which have been adjusted to conform to the findings of the revenue agents during those years. [1912] ASSETS Cash $2,320.28 $9,341.39 Accounts receivable 19,589.02 $23,219.71 $22,749.46 $22,138.26 25,711.21 Bills receivable 48,600.00 Stocks and bonds Inventories 78,043.80 77,421.50 89,617.26 50,618.08 66,233.94 Real estate 13,837.75 13,837.75 13,837.75 13,837.75 13,837.75 Buildings 65,285.04 65,285.04 65,285.04 65,285.04 65,285.04 Machinery 129,311.24 129,311.24 129,311.24 129,311.24 133,908.60 Other assets 1,144.46 13,498.60 17,328.03 19,620.97 2,422.77 309,531.59 322,573.84 338,128.78 300,811.34 365,340.70 LIABILITIES Capital stock 22,000.00 22,000.00 22,000.00 22,000.00 22,000.00 Surplus and undivided profits 120,364.96 81,654.75 146,514.23 160,879.37 143,985.27 Profit and loss 104,289.79 86,859.48 36,365.14 49,105.90 64,035.88 First mortgage bonds 50,000.00 50,000.00 Accounts payable 12,876.84 10,840.22 14,882.65 14,492.43 17,689.73 Bills payable 60,000.00 55,000.00 Depreciation reserve 15,542.52 31,085.04 46,627.56 62,629.82 Accrued liabilities Overdraft in bank 55,676.87 27,281.72 7,706.08 309,531.59 322,573.84 338,128.78 300,811.34 365,340.70 *2917 The financial condition of the petitioner for the years 1913 to 1917, inclusive, is set forth in the following balance sheets, which have been adjusted to conform tothe findings of the revenue agent *137 for those years, except for slight discrepancies in 1913, 1914, and 1915: [1917] ASSETS Cash $3,622.07 $5,785.97 $13,948.78 Accounts receivable 31,083.28 28,988.75 $39,364.71 76,580.22 $145,380.04 Bills receivable 23,554.92 5,000.00 Stocks and bonds 100,000.00 Inventories 95,637.70 96,732.06 322,508.09 398,211.34 187,440.83 Real estate 13,837.75 13,837.75 13,837.75 13,807.75 13,807.75 Buildings 65,285.04 65,285.04 70,841.42 77,382.98 77,382.98 Machinery 134,293.56 134,700.93 140,612.43 155,354.21 158,701.69 Other assets 1,885.43 1,914.14 1,832.26 11,476.01 Unlocated difference 1,975.61 158.95 369,199.75 354,220.25 589,155.61 746,761.29 682,713.29 LIABILITIES Capital stock 22,000.00 22,000.00 22,000.00 22,000.00 22,000.00 Surplus and undivided profits 154,024.42 135,055.87 19,560.07 130,888.52 94,435.57 Profit and loss 53,128.87 60,223.20 328,411.33 254,523.66 281,596.75 First mortgage bonds Accounts payable 17,778.23 22,189.10 57,720.55 29,071.37 36,499.83 Bills payable 40,000.00 20,000.00 40,000.00 180,000.00 60,000.00 Depreciation reserve 78,670.58 94,752.08 111,646.99 130,277.74 169,678.28 Accrued liabilities 1,551.65 Overdraft in bank 9,816.67 18,502.86 Unlocated difference 2,046.00 369,199.75 354,220.25 589,155.61 746,761.29 682,713.29 *2918 The average net tangible assets owned by petitioner for the years 1908 to 1912, inclusive, was $220,810.95. The net income for the years 1908 to 1917 inclusive, which agrees with the determination of the revenue agent, except as to 1911, was as follows: Year Amount [1908] $ 104,289.79 [1909] 86,859.48 [1910] 36,365.14 [1911] 49,105.90 [1912] 64,035.88 [1913] $53,128.87 [1914] 60,223.20 [1915] 328,411.33 [1916] 254,523.66 [1917] 281,596.75 The petitioner sustained a loss in 1919 of $17,782.85, and in 1920 of $13,447.32, and for 1921, $17,714.29. The patent in controversy cost the petitioner about $150, which was for attorney and registration fees. The value of that patent at March 1, 1913, was $275,000. At the outbreak of the European war there was a tremendous increase in the demand for purified cotton fiber, and upon the entry of the United States into the war in 1917 there was a further increase in the demand for this product. During the war years the maximum monthly production of smokeless powder by the du Ponts increased from 500,000 pounds to 48,000,000 pounds. The petitioner's plant was operating night and day during 1917. A great number of other*2919 *138 companies entered into the manufacture of a similar product for munitions purposes, but the petitioner paid little or no attention to them, or to the processes employed, to determine whether its patent rights were being infringed, because its plant was operating at capacity, and the du Pont Company was consuming the largest part of its product. Upon the signing of the Armistice in 1918, there being an enormous supply of gun cotton and gun powder on hand sufficient to meet normal demands for several years thereafter, the du Pont Company discontinued the purchase of bleached cotton fiber and there was no demand for the petitioner's product whatsoever, and its plants were closed down on November 15, 1918. This condition petitioner's officers foresaw in 1917; they considered that after the close of the war its plants would be valueless. The petitioner's representatives took up the matter of their tax obligation to the United States Government with the Bureau of Internal Revenue in Washington in 1919, and they were advised that they should attempt to rehabilitate the business, and save what they could, and that they would be protected under article 143 of the Regulations, *2920 and that if money were lost in its attempt to rehabilitate, that loss might be charged against other years. As a result of that advice the company decided to spend money in an effort to rehabilitate and to make paper pulp, spending in that direction $52,000 but failed utterly to make a pulp that was commercially profitable or satisfactory. The pulp so experimented with was shipped to paper mills but no repeat orders were received. The only business done by the petitioner after it closed down in 1918 was of an experimental nature, which experiments were abandoned in the latter part of 1921. In computing its net taxable income for 1918 the petitioner claimed a deduction for obsolescence or a "loss of useful value" of its patent for the period November 11, 1918, to December 31, 1919, occasioned by the cessation of business operations in that year due to lack of demand for its product after the close of the World War, which the respondent disallowed. The respondent reduced the petitioner's invested capital for the year 1918 by the amount of income and profits taxes for the year 1917 and he also reduced invested capital by an amount of tentative tax computed for the purpose of*2921 ascertaining current earnings available for dividends. OPINION. MORRIS: The first allegation of error relates to the failure of the respondent to allow a deduction for obsolescence, exhaustion, wear and tear or loss of a patented process which became, as the petitioner *139 alleges, exhausted and obsolete and therefore a complete loss in the year 1918. The respondent contends that the deduction claimed should not be allowed for the reason that there is no competent evidence to support the March 1, 1913, value as contended for, and that even assuming that said value has been clearly evidenced, the facts do not justify the deduction as obsolescence under section 234(a)(7), the loss, if one has been sustained, is a loss of useful value, not obsolescence, and therefore the basis for determining the deduction is the cost of the patent and not its March 1, 1913, value. If a deduction is allowable, authority therefor must be found in one of the following subdivisions of section 234(a) of the Revenue Act of 1918: (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions: * * * (4) Losses sustained*2922 during the taxable year and not compensated for by insurance or otherwise; * * * (7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. We disagree with counsel for the respondent that the value of the patent is unsupported by the evidence. Considering the earnings of the petitioner for the several years prior to March 1, 1913, which are unquestionably in large part attributable to the patented process, the marketability of its product at that time, the lack of competition, and the future prospects of the business after that date, together with the positive testimony of men who were at all times during the life of the petitioner in intimate contact therewith, we have found as a fact that the patent in question had a value at March 1, 1913, of $275,000. The respondent offered copies of certain letters patent in evidence for the purpose of rebutting the testimony that the petitioner had a monopoly on the manufacture of purified bleached cotton fibers from low-grade cotton linters. No evidence was offered as to whether the processes covered by these patents were in use, or if*2923 they were, that they were identical or even similar to those employed by the petitioner. We can, therefore, attribute no value to this evidence. It must be conceded at the outset that the manufacture of gun cotton base was hopelessly imperiled at the close of the World War in 1918, due to the oversupply of gun cotton and gun powder, enough, it was testified, to supply the needs of the world for four or five years, and a consequent sudden cessation in demand for that product. In 1917 the petitioner believed its business would be absolutely at an end and its plants valueless at the close of the war. Immediately after the signing of the Armistice its plants were closed down and operations were never thereafter resumed, except for a futile attempt *140 which was made during 1919, 1920, and 1921 to divert ist product to the manufacture of paper. We must also concede that the success or failure of the petitioner depended entirely upon the product manufactured under the patent which it claims became obsolete in 1918. But do those factors, without more, render the patent itself obsolete, within the meaning of the statute? *2924 Webster's New International Dictionary defines "obsolescent" or "obsolescence," "to wear out gradually; to fall into disuse," and the word "obsolete" is defined to mean "no longer in use; disused; neglected; as, an obsolete word; an obsolete statute." Obsolescence as used in the statute is the state or process of becoming obsolete and the provision allowing a deduction therefor is intended to care for losses of capital which take place over a longer period than the taxable year. William Zakon,7 B.T.A. 687. The state of obsoleteness is reached when the property which can not be used for any other purpose is no longer economically useful for the purpose for which it was acquired, Frederick C. Renziehausen et al.,8 B.T.A. 87, and is therefore abandoned. It could be foreseen, after the signing of the Armistice, that the market as a base for explosives, for the product manufactured under the patent was completely wiped out during the remaining life of the patent. The patent, or the process protected thereby was not abandoned, however. While the petitioner closed its plant in 1918, it engaged in experimental work in the hope that it would succeed*2925 in diverting its product to the manufacture of paper, a use for which the petitioner had been more or less successful in disposing of its product prior to the execution of the contract with the du Pont Company. We are satisfied that had the petitioner been convinced in 1918 that its patent was obsolete for all purposes, it certainly would not have spent $50,000 or more in trying to revive a former use. In this connection it is interesting to note the language used by this Board in Yough Brewing Co.,4 B.T.A. 612, wherein the Board said: * * * It is urged that the taxpayer should not be made to suffer because it in effect attempted to increase the amount of salvage when it knew there was small chance of successful operation. This argument presupposes that the taxpayer was attempting only to realize salvage, a premise with which we do not agree. We must presume that the taxpayer's officers were exercising their best business judgment and that in so doing they saw a reasonable prospect of a profitable business in near beer. We can not credit them with power to prophesy in 1919 that the public would not take to near beer. If that fact could have been foreseen would*2926 they have gone into the near beer business? We think not. Because their expectations for profitable business were not realized, they can not now maintain that the plant was obsolete when they began making near beer. Considering all the facts and circumstances we are of the opinion that the patent did not become obsolete during the year 1918. *141 In our decisions relied upon by the petitioner the assets claimed to have become obsolete or valueless within the taxable year, upon which a claim for deduction was based, were tangible property, definitely discarded or abandoned within the taxable year, and either completely charged off in the books of account or the value thereof written down to a junk or scrap value. Here the value of the asset was not carried in the books of account, and for that reason could not have been charged off within the taxable year as was done in those cases, but the patent was not abandoned. The product was manufactured thereunder, and shipped to various paper mills in an attempt to establish a market in that trade. We are also of the opinion that the petitioner is not entitled to a deduction under section 234(a)(4) of the Revenue Act of*2927 1918. As already pointed out, the patent was not discarded during 1918, nor at the close of that year was it established that it was valueless. Tax liability is determined upon the basis of annual accounting periods, and when a determination is made for a given year, the facts and conditions occurring and existing during such year must be the basis upon which we predicate our action. H. P. Robertson Co.,14 B.T.A. 887. We found as a fact that the patent had a March 1, 1913, value of $275,000. The petitioner is therefore entitled to a deduction for exhaustion based on that value and a life extending to July 20, 1920. J. J. Gray, Jr.,2 B.T.A. 672. The second allegation of error herein was expressly withdrawn by petitioner's counsel at the hearing of this proceeding. L. S. Ayers & Co.,1 B.T.A. 1135, is determinative of the third allegation of error herein. Reviewed by the Board. Judgment will be entered under Rule 50. TRAMMELL dissents.