International Tag Co. v. Commissioner

INTERNATIONAL TAG CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. International Tag Co. v. Commissioner Docket No. 19587. United States Board of Tax Appeals 18 B.T.A. 309; 1929 BTA LEXIS 2081; November 21, 1929, Promulgated *2081 Petitioner held not entitled to computation of its tax under section 328 of the Revenue Act of 1918. Clarence N. Goodwin, Esq., for the petitioner. G. S. Herr, Esq., for the respondent. PHILLIPS *309 This proceeding results from respondent's determination of a deficiency in income and profits taxes for 1920 in the amount of $4,372.01, all of which is in controversy. Error is alleged in respondent's refusal to determine the profits tax under sections 327 and 328 of the Revenue Act of 1918. By motion under Rule 62, which was duly granted, the hearing was limited to the question whether petitioner is entitled to have its tax determined under section 328. FINDINGS OF FACT. Petitioner is a New Jersey corporation with its principal office and place of business at Chicago, Ill. Its principal business in 1920 was the manufacture of shipping tags. In 1906 petitioner ordered five tag-making machines from the Appleton Machine Co. When they were received it was found the inking device was not strong enough for the desired speed. The roller traveled twice (across and back) over the type to one inking device. The printing mechanism of*2082 the machine was discarded and a new one designed with an inking device which necessitated the roller traveling but once over the type, which permitted the press bed to be operated more rapidly with a slower motion on the roller. This improving device was designed by petitioner's employees and Letters Patent No. 930497 were later issued thereon under date of August 10, 1909. *310 This inking device permitted the printing machines to be operated at 110 impressions per minute, an increase from 80 impressions per minute rate attained theretofore by petitioner and during the year in question by competitors. A device was perfected by which the tympan block on the machine was lowered to a normal working position which facilitated the "make ready," i.e., work of putting a job on the press ready to start running, getting the printing perfected, studying the color of the ink, etc. The time consumed in the process of making ready was thus reduced materially with resultant labor savings on wages of the pressman, who received 90 cents per hour, and his two helpers who operated the machine and received from 30 to 35 cents per hour. Other improvements in mechanical devices and processes*2083 were subsequently worked out by petitioner's officers and employees from time to time and were in operation in petitioner's plant during 1920. One of these was a device for cutting and attaching patches to the tags to strengthen them. This device was covered by Patent No. 981,014 issued January 10, 1911. Another of these devices was used for putting the metal eyelet in tags. Theretofore petitioner had been putting the eyelets in by hand. This device betaine a part of the printing machine, so that the two operations could be carried on at once without loss of time. It was never patented. A method was then devised of operating the patching and eyeletting devices in a double row. This increased the capacity on tags requiring patches (which strengthen the tags, preventing their being torn in shipment) and eyelets to 6 tags at one operation of the printing machine, while those requiring only perforation and patching could be run eight at one time. Petitioner also developed a stringing and wiring machine to put strings and wires in tags, which theretofore had been done by hand at heavy labor costs. The above devices substantially increased the capacity, which served to reduce*2084 the proportionate cost of indirect labor and overhead. The year in question was a rush year in which the trade was running at capacity. The devices, appliances, and methods were kept secret from the trade as far as possible. Competitors were not allowed to go through the factory. Only two of the devices were patented, as petitioner considered it could better keep them secret if patents were not taken out. One machinery company attempted to copy the improvement in the inking device on printing presses and sold several of the machines it made to a competitor. Such machines were, however, so clumsy in operation that they failed to increase capacity. Petitioner never sold any machines in the United States, preferring to profit from its inventions by the competitive advantages derived *311 from their exclusive use rather than from the sale of machines. They, however, sold four machines to a Canadian firm and one machine to an English firm, neither of which could be classed as competitors. The first two machines sold, one in 1917 and one in 1919, to the Canadian firm, were two of the original machines ordered by petitioner from the Appleton Machine Co. at a cost of about*2085 $1,000. The respective sale prices of such machines were $4,796.85 with extras of $521.77, and $4,500 with extras of $254.82. In 1921 a machine ordered in 1920 by petitioner at a total cost of $4,409 and an appliance made by petitioner at a cost of $45 was sold to the Canadian firm for $9,750 with extras of $878.50. Later in the same year a like transaction was completed with the same firm (the extras amounting to $279.05) and a similar one in the same year with an English firm with extras amounting to $6,590. These five were the only machines ever sold by petitioners. The above mentioned devices, appliances and processes were developed by employees while on the pay roll of petitioner. The patents were carried on the books at $10,294.10, as of January 1, 1920, and at $8,823.51 as of December 31, 1920. Petitioner had a number of Government contracts during the year 1920. They were acquired on a competitive bid basis. The Government contracts represented not more than 25 per cent of the business done, which was not greater than the usual proportion. Petitioner handled envelopes and kindred lines as a jobber during the year 1920 as it had formerly done. It did so only*2086 as an accommodation to its salesmen, who sold such goods as a sideline. The volume of this line of business and the profit therefrom did not exceed 1 per cent of petitioner's gross for the year. Petitioner's return for the year shows gross sales less returns and allowances $1,563,087.57; less cost of goods sold, exclusive of expenses, repairs and other items called for separately, $792,336.90 - the difference carried out being $770,750.67. Gross income from operation other than trading or manufacturing less allowances from schedule A 3-1, sale of waste, etc., was $12,156. Taxable interest from all other income, bank notes and accounts receivable was $1,389; rentals were $3,915.16; gross income from all other sources - none; gross income, $788,210.87; deductions, $503,115.57. The net income used in computing the deficiency was $268,904.59, while the invested capital used was $392,858.42. OPINION. PHILLIPS: The claim of petitioner that it falls within section 327 of the Revenue Act of 1918 and is entitled to a computation of its tax under section 328 is based on the ownership of two patents, *312 together with certain secret mechanical devices and processes used in*2087 the conduct of its business which it claims do not appear in its invested capital but which are responsible for part of its income. A balance sheet submitted in evidence shows that patents were carried at $10,294.10 as of January 1, 1920, and at $8,823.51 as of December 31, 1920. The difference of $1,470.59 must represent a reduction for exhaustion of such patents, as the testimony negatives the ownership of any other patents or the sale of any patents during the year. The life of a patent is 17 years. Multiplying the annual exhaustion by 17 we arrive at an original cost for these patents of $25,000. A similar mathematical computation will indicate that exhaustion began January 1, 1911, on a basis of a life of 17 years. One of the patents which petitioner claims was not included in invested capital was granted in 1909 and the other in January, 1911. Both were granted to the petitioner as assignee of the applications for patents, such applications having been filed by employees. The evidence leads to the conclusion that one or both of these patents were acquired at a cost of $25,000 and are carried on petitioner's accounts at their depreciated cost. The further conclusion may*2088 properly be drawn that in computing income for the year in question a deduction was allowed for exhaustion of this cost. The petitioner had also perfected an attachment which permitted the tympan to be lifted to normal working height and another which permitted metal eyelets to be attached at the time the tags were printed and cut. The testimony is that competitors had similar features on their machines but not designed the same as those of petitioner. It is very evident that the petitioner had devised a very efficient tag-printing machine and had installed attachments which permitted the tags to be patched, eyeletted and cut, and wire or string to be inserted, all as a part of the same series of operations. The testimony indicates that these devices were more efficient than those formerly employed by petitioner and, in some respects at least, more efficient than those employed by competitors. These improvements represented the work of employees, and, except to the extent of $25,000, no cost is reflected on the books of account. That without these devices the petitioner could not have produced the volume of work done during 1920 is beyond question. But in determining the question*2089 of abnormality we are not to consider alone whether the devices used during the taxable year were more efficient than those used in past years. The industrial and mechanical arts are steadily improving and greater production is steadily being obtained. Increased mechanical perfection permitting greater production is not an abnormal situation. When these processes are so protected either by patent or as trade secrets, that they are available *313 only to the taxpayer and their use in the business produces an abnormality in capital or income that, without the benefit of section 328, would work upon the corporation an exceptional hardship in tax, as defined in section 327 of the Revenue Act, the taxpayer is entitled to the benefits of the section. Cushman Chuck Co.,8 B.T.A. 148; Viscose Co.,3 B.T.A. 444. But the mere presence of valuable processes is insufficient to establish an abnormality. Here the improvements in the printing mechanism, which were probably responsible for much of the progress made by petitioner, were included in invested capital. The comparative value of the improvements which were not included is not shown, and it*2090 appears that competitors had other devices for performing some of the same services. The evidence does not indicate any unusual transaction which made the income of the petitioner for the taxable year abnormal, nor does it establish that assets owned by petitioner were excluded from invested capital to the extent which would lead to the belief that an exceptional hardship will result unless the taxpayer is given the benefits of section 328. Reviewed by the Board. Decision will be entered for the respondent.