International Cigar Mach. Co. v. Commissioner

INTERNATIONAL CIGAR MACHINERY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. International Cigar Mach. Co. v. Commissioner Docket Nos. 71331, 76285. United States Board of Tax Appeals 36 B.T.A. 124; 1937 BTA LEXIS 763; June 16, 1937, Promulgated *763 Petitioner, who was the owner of patents on cigar making machines, contracted with cigar makers to supply them with the patented machines in consideration of (a) lump sum payments and (b) royalties based on the number of cigars made. The lump sums specified in the contracts were equivalent to the amounts that it would cost to have the machines made by a manufacturing company, the petitioner having no facilities of its own to manufacture the machines. On receipt of lump sums the petitioner deposited them in its regular bank account, but entered them in separate accounts on its books. On completion of the machines by the manufacturing company, it shipped them direct to the cigar makers and the petitioner paid over to it the lump sums with appropriate entries to clear such sums from its books. Held, that in the receipt and disbursement of the lump sums subject to the contracts there was no gain, hence no income, to the petitioner. Robert H. Montgomery, Esq., Thomas G. Haight, Esq., J. Marvin Haynes, Esq., and James O. Wynn, Esq., for the petitioner. P. M. Clark, Esq., and S. B. Pierson, Esq., for the respondent. ARUNDELL *124 *764 The respondent determined deficiencies in income taxes and asserted fraud penalties against the petitioner, as follows: Year Docket No. Deficiency Penalty [1929] 71331 $121,606.92 $60,803.46 [1930] 71331 278,638.69 139,319.35 [1931] 76285 105,476.35 In his amended answer respondent admits error in asserting penalties. The petitioner challenges the correctness of respondent's determination, setting forth several assignments of error in the petitions. Some of those assignments have been settled by stipulation, which will be given full effect in the recomputations to be made under Rule 50. The remaining issues for decision are as follows: (a) Whether the amounts of $1,840,500, $2,984,700 and $1,138,700 received by the petitioner in 1929, 1930 and 1931, respectively, under certain agreements with licensed users of cigar making machines manufactured under patents owned by the petitioner, constitute taxable income; (b) Whether the cost of development of a patent for a Fresh Work Cigar Machine, which was owned by the petitioner throughout the taxable years, should be exhausted over a seventeen-year period beginning April 6, 1915, the date the patent was*765 issued to the petitioner, or over a like period beginning March 1, 1913, application for the patent having been made prior to the latter date; and *125 (c) Alternative to (a), and in the event it is held that the amounts therein mentioned constitute taxable income, whether the deductions allowed by the respondent for depreciation of cigar machines are reasonable. In addition to the above, the respondent, in his amended answer, claims additional deficiencies of $74,683.49 for 1929 and $65,863.28 for 1930, on the ground that he erroneously allowed excessive deductions of (1) $130,862.50 for 1929 and $7,125 for 1930 for "loss on machines returned and scrapped, etc." and (2) $548,078.29 for 1929 and $541,735.79 for 1930 for depreciation of cigar machines. The proceedings, submitted upon agreed statements of facts and oral testimony, have been consolidated for hearing and decision. FINDINGS OF FACT. The petitioner, a New Jersey corporation with its principal office at 511 Fifth Avenue, New York City, was organized in 1901. Capital stock of $10,000,000 was issued for certain cigar machinery inventions and approximately $130,000 in cash. From July 1, 1912, to the present*766 time the American Machine & Foundry Co. has owned from 65 3/8 to 67 1/2 percent of the stock of the petitioner. For the period that consolidated returns were permitted by the law and the regulations, the petitioner and the American Machine & Foundry Co. were not treated as affiliated corporations and were not permitted to file consolidated returns for Federal income tax purposes. By 1905 a machine was perfected for the manufacture of mould cigars. In 1905 over one hundred mould cigar machines were manufactured under the patents of the petitioner, and contracts were made with cigar manufacturers for the use thereof during the life of the patents on a stipulated royalty basis. All of these mould cigar machines were manufactured by the American Machine & Foundry Co. Later the mould cigar machine was improved to use metal moulds rather than wooden moulds. This improved machine thereafter was called the soft work cigar rolling machine. The following tabulation shows the number of mould cigar and soft work cigar rolling machines out on patent royalty contracts each year during the period 1913 to 1931, inclusive: Year Number [682] *767 After perfecting the mould machine, the petitioner begun the development of the fresh work cigar machines. By April 6, 1915, *126 this machine was perfected and a patent therefor (U.S. Patent No. 1,134,246) was issued on that date on an application filed prior to March 1, 1913. Immediately prior to 1915 two model fresh work cigar machines had been manufactured and were on demonstration. After the patent was issued it was necessary to rebuild the machines so that they would manufacture a differently shaped cigar. The changes necessary to bring about this result were completed in 1916 and 1917, and shipments of machines to cigar manufacturers were started in 1918. The following tabulation shows the total number of fresh work cigar machines under patent royalty contracts at December 31 of each year during the period 1915 to 1931, inclusive: Year Number [1915] 1 2 [1916] 1 2 [1917] 1 2 [1924] 1,010 [1925] 1,331 [1926] 1,953 [1927] 2,506 [1928] 2,755 [1929] 3.087 [1930] 3,725 [1931] 3,931 *768 The fresh work cigar machine differs from the soft work rolling and automatic mould rolling machines in that it takes up the mechanical operation at an earlier stage. The soft work and automatic mould machines do not mechanically form the filler of the cigar. This is done by hand by means of wooden and metal moulds. After a mould has been filled by hand, the machine automatically picks up the moulded forms and places binders and wrappers around them. The fresh work machine, however, does away entirely with the mould operation by hand. Tobacco in a freshly conditioned state is placed in a trough from which it is automatically fed into the machine, all ensuing operations being performed by the machine, which turns out a finished cigar. In other words, the cigar is manufactured entirely by machine. The soft work and mould rolling cigar machines are used in the manufacture of cigars which are made primarily of short filler. The short filler requires the moulds which must be filled by hand. The fresh work machine is used almost universally where eigars are made out of long filler tobacco. The petitioner borrowed a large part of the money to carry on its experimental development*769 work in connection with perfecting the mould and the fresh work cigar machine patents. After the machines had been developed commercially, the petitioner made an arrangement with the American Machine & Foundry Co. to manufacture the machines at set prices. The American Machine & Foundry Co. was selected not only because it owned stock of the petitioner, but because the machine was a complicated one and the petitioner believed *127 that that company had the experience and skill to manufacture these machines. The petitioner was unable to manufacture the machines because it had no plant of its own. In the contracts made during the latter part of 1917, the set price was $2,000 per machine. During the latter part of 1918 the price was increased by the American Machine & Foundry Co. to $2,500 per machine, and in the summer of 1919 to $3,800 per machine. During 1929, 1930, and 1931 the set price was from $3,800 to $4,500 per machine, depending on the type of attachments included therein. The American Machine & Foundry Co. made a profit of about 25 percent on the construction cost of the machines, and that company has reported this profit for income tax purposes. The mould*770 cigar and the soft work cigar machines had a very limited market. By 1917 or 1918 the fresh work cigar machine had become commercial. At about that time the petitioner considered the question as to how it was to enjoy revenue from its patents and patent applications in respect to the cigar machines. The petitioner was the owner of patents that it determined to be of great value. It also had patent applications pending. However, the petitioner had no facilities for making the cigar machines. One method suggested by which the petitioner might enjoy an income from the patents it owned was to sell the cigar machines. It was found that this method of selling machines, in this country at least, was not feasible, for the reason that cigar manufacturers had not sufficient financial ability to justify them in paying a price, in addition to the cost of construction of the machines, that would be an adequate compensation to the petitioner. Upon consideration this method was rejected. Another plan considered was that shop rights might be given so that the cigar manufacturer would construct his own machines. This method was rejected because the machine was complex in its construction*771 and it was thought that if the petitioner gave a cigar manufacturer the right to build the machine, and he went to any machine shop he pleased to have it constructed, or tried to construct it himself, an unworkable machine would result and the patented machine would, therefore, quickly become an unpopular machine. The plan that was finally adopted was that the petitioner would have the cigar machines built by the American Machine & Foundry Co., in whose shops and personnel the petitioner had confidence; that the petitioner should collect from the cigar manufacturer precisely the amount to be paid to the American Machine & Foundry Co. for the construction of the machine; and that the machine would be turned over to the cigar manufacturer upon the basis of royalty payments based upon the number of cigars made or the per diem use of the machines. Having adopted this plan as a method of realizing income from its patents *128 and patent applications, the petitioner proceeded to work out, in conjunction with cigar manufacturers, forms of contracts. Omitting signatures and attestations, the following is a specimen copy of the contract used for fresh work cigar machines, and is*772 substantially identical with contracts made between the petitioner and users of all types of machines during the period 1917 to 1931, inclusive: AGREEMENT Agreement made this day of 19 between the International Cigar Machinery Company, Incorporated, a New Jersey corporation, hereinafter called "Lessor" and , hereinafter called "Lessee". In consideration of the respective agreements and covenants made by the parties hereto, and of the sum of Dollars per machine, paid by Lessee to Lessor upon execution of this agreement, the parties hereto agree as follows; Lessor Covenants and Agrees as Follows: (a) Lessor hereby leases to Lessee, and licenses Lessee to use within the United States of America, as now constituted (exclusive of Porto Rico, Hawaii and the Philippine Islands) and the Dominion of Canada, but not elsewhere Lessor's Fresh Work Cigar Machines Nos , inclusive, for a term of years to continue for the life of any of the United States Letters Patent, which are, or purport to be, embodied in the said machine or machines now leased, and thereafter for the life of any such Letters Patent which are, or purport to be, embodied, in any new part or parts, attachment*773 or attachments, improvement or improvements, hereafter made in or added to said machine or machines. (b) Lessor will begin delivery of said machine or machines hereby leased to Lessee f.o.b., Brooklyn, New York, weeks after the receipt by the Lessor of complete, correct, written specifications and models, approved by Lessor and shall deliver said machines at the rate of machines per week thereafter, subject to delays in delivery caused by strikes, fires, riots, war, injunction or other force major. (c) Lessor will furnish Lessee upon Lessee's written request, at a price equal to the cost to the Lessor, all parts necessary to replace broken or worn out parts of the machine or machines hereby leased, and any new parts which Lessor may hereafter manufacture as improvement on or additions to its Fresh Work Cigar Machines, which improvements or additions shall be attached to said machines or not at the option of the Lessee. If any machine hereby leased shall be substantially destroyed or incapacitated for further use without reconstruction, or substantial repair, Lessor will, upon return to it of such machine, reconstruct it at Lessee's expense, or at Lessor's option may replace*774 it with a new machine of the type then regularly supplied by Lessor upon payment by Lessee to Lessor of Thirty-eight Hundred Dollars ($3,800), or if the machine is equipped with Cross Feed, Forth-five Hundred Dollars ($4,500), and execution by Lessee of a new lease covering said machine; or if any machine hereby leased shall be totally destroyed and Lessee shall furnish sufficient proof of such total destruction, Lessor will furnish a new machine to Lessee upon payment of Thirty-eight Hundred Dollars ($3,800), or *129 if the machine is equipped with Cross Feed Forty-five Hundred Dollars ($4,500), and execution by Lessee of a new lease covering said new machine. If improvements or additions have been made to any machine so to be replaced, there shall be added to the replacement cost of the machines aforesaid, the cost of renewing said improvements or additions. The right of reconstruction and/or substantial repair as aforesaid is vested solely in Lessor. (d) If Lessee shall cease the business of manufacturing and making cigars and shall disire to terminate this lease as to any machine and shall pay to Lessor full minimum royalty for such calendar year, Lessee may deliver*775 to Lessor at Lessee's expense such machine or machines in good condition, ordinary wear and tear excepted, thereby waiving all right to any sums paid pursuant to clause (1) hereunder, and upon such delivery the within lease shall thereupon terminate; or upon fulfillment of the conditions mentioned above in this clause Lessor will cancel this lease and give to Lessee written permission to assign such machine to any person, firm or corporation satisfactory to Lessor, provided such assignee shall execute and deliver to Lessor an thereafter be liable only for such indebtedness and liability as shall have accrued hereunder prior to or upon such termination. (e) Lessor will, at its own expense, defend all suits or proceedings instituted against Lessee insofar as the same are based on any claim that the said machine or machines, or any part or parts thereof, constitute an infringement of any patent of the United States or Canada, provided Lessee gives Lessor immediate notice in writing of the institution of the suit or proceeding, and permits Lessor, through its counsel, to defend same, and gives Lessor all needed information, assistance or authority to enable Lessor so to do, and provided, *776 further, Lessee makes no change of any kind in said machine or machines without obtaining written permission of Lessor. (f) Upon the expiration of this contract as provided in Clause (a) herein, Lessee having well and truly done and performed all and singular its covenants and agreements herein, Lessor will sell and deliver to Lessee the said machine or machines hereby leased at the price in cash to be paid contemporaneously by Lessee to Lessor of Two Thousand Two Hundred and Fifty Dollars ($2,250) per machine. (g) With the exception of leases entered into pursuant to Clauses (c) and (d) hereinabove or pursuant to any transfer of machines, Lessor will not hereafter during the term of this lease enter into any contract for lease of similar Fresh Work Cigar Machine or machines for use in the territory described in Clause (a) herein to any person, firm or corporation at lower rates of rental or royalty than is provided in Clause (2) herein to be paid by Lessee, without prompt notification given to Lessee of such lease. During the entire time such other person, firm or corporation is enjoying such lower rates than is provided in Clause (2) herein to be paid by Lessee, Lessor will*777 accept and receive from Lessee in lieu of the rental provided for in Clause (2) herein, a like lower rental, to the end that no cigar manufacturer hereafter entering a like lower rental, to the end that no cigar manufacturer hereafter entering into the contract of lease with Lessor (with the exceptions aforestated) shall enjoy during the term of this lease lower rates for the use in said territory of similar machines of Lessor in making cigars of the same grade than Lessee at the time enjoys. (1) Lessee will pay Lessor upon execution of this agreement, One Thousand Dollars ($1,000) in New York Funds, for each machine covered hereby, and agrees to pay the balance of Dollars ($ ) either (a) upon receipt of notice that said machine or machines are ready for *130 delivery, or (b) at the option of the Lessee to pay One Thousand Dollars ($1,000) for each machine covered hereby upon receipt of notice that said machine or machines are ready for delivery, and the balance then remaining by three negotiable promissory notes of Lessee made and delivered to the order of Lessor and payable respectively three, six and nine months from date of such receipt of notice and bearing interest*778 at the rate of six per cent per annum. Lessee shall not at any time after the delivery to it of each respective machine have or claim any repayment of any sums paid hereunder as aforesaid or any part thereof. Each machine leased hereby, including additions or improvements thereto, is and shall remain the exclusive property of Lessor and Lessee by this agreement acquires no ownership or title therein, and the only right conveyed hereby is the right to use said machine or machines upon the conditions herein set forth. Lessee will pay the cost of installation, demonstration and maintenance of said machine or machines in lessee's premises. (2) Lessee will further pay Lessor during the period of this lease commencing thirty (30) days after receipt of notice that said machine or machines are ready for delivery, as rental for the use of said machines and each of them, One Dollar ($1.00) per each thousand cigars produced by such machine or machines. Lessee covenants and agrees to pay to Lessor a minimum rental or royalty annually equal to Three Hundred Dollars ( $300) multiplied by the number of machines leased by Lessor to Lessee. Rentals or royalties shall be paid by Lessee to Lessor*779 on or before the twentieth day of each month for rent accrued to the last day of the preceding month. On or before the fifteenth day of each month, Lessee will give Lessor a written statement of all cigars produced by said machine or machines during the preceding month and will upon Lessor's request permit the inspection by Lessor's representatives of said machine or machines and of Lessee's books and documents relating to the manufacture of cigars. Lessee's liability to pay said rentals shall not during the continuance of this lease cease or be suspended for any cause whatsoever except only while Lessee's use of the machine is stopped by injunction granted by a competent court in suit for infringement of patent. (3) Lessee will not at any time make any change of any kind in said machine or machines without obtaining written permission of Lessor, and will not at any time use any cigar making machines which infringe on any of Lessor's patents, and will not, directly or indirectly, violate, infringe or contest the validity of any of Lessor's patents with respect to cigar making machinery or the title of Lessor to any such patents. Lessee will give Lessor immediate written notice*780 of any suit or proceeding instituted against Lessee insofar as the same is based on any claim that the said machine or machines or any part or parts thereof constitute infringement of any patent of the United States, or Canada. Lessee further agrees that if any improvements or inventions are made by Lessee or any officer, member, or employee of Lessee to or in connection with said machine or machines or similar machines, Lessee will give Lessor immediate written notice of such improvements or inventions and will give Lessor the right (so far, if such improvement or invention is that of an officer, member or employee of Lessee, as it may be within the right of Lessee so to do) in the name of Lessee or such officer, member or employee, to apply to the United States Patent Office and Patent offices of foreign countries for Letters Patent to cover such improvements or inventions and to give Lessor all immediate information, assistance and authority to enable Lessor to apply for Letters Patent. Said improvements or inventions shall forthwith be and become the property of Lessor. All expense in connection with the application for any Letters Patent shall be borne by the Lessor. *131 *781 (4) Lessee will not use said machine or machines outside of the territory specified in Clause (a) and will not sell, sublease, encumber, remove or otherwise dispose of the same, as provided in Clause (d), without the prior express written permission of Lessor duly executed by its duly authorized officers, but Lessee may sell the products of sai machine or machines in any territory. (5) Lessee will at all times at its expense keep said machine or machines in efficient working condition and will not deface or injure said machine or machines. (6) Lessee will pay all taxes and assessments that may be levied on said machine or machines, or any interest therein, during the term of this lease, and shall at its expense at all times keep each machine insured to the amount of at least Thirty-eight Hundred Dollars ($3,800) or if said machine is equipped with Cross Feed, Forty-five Hundred Dollars ($4,500), or if improvements or additions have been attached (as provided in Clause (c) hereinabove) to any machines so to be insured, the above amounts plus the cost of such improvements or additions, against partial or total loss by fire or water for Lossor's benefit. Any insurance money received*782 by Lessor shall be deducted from cost of repairs or price of new machines as provided in Clause (c) herein. Lessee will deliver the policies of insurance to the Lessor, and the Lessor shall be entitled to receive all insurance money collected under said policies. (7) Lessee covenants that if at any time Lessee becomes insolvent or bankrupt or makes a general assignment for the benefit of creditors, or if a receiver of Lessee is appointed, that this lease shall forthwith terminate, and that if Lessee violates any of the covenants set forth herein, Lessor may terminate and cancel this lease and any other leases between the parties hereto, at the expiration of thirty days after mailing written notice stating the convenant or convenants herein violated to Lessee by registered mail addressed to Lessee's office at unless Lessee shall remedy such violation or violations within said thirty days, and upon such termination of this lease, Lessee shall at its expense deliver to Lessor at Lessor's nearest factory, said machine or machines complete with all their parts in good working order, ordinary wear and tear excepted. (8) Upon termination of this lease in any manner, except as provided*783 in clause (d) herein, possession of said machine or machines shall thereupon revest in Lessor, free and discharged of this lease, and Lessor, or its authorized agent, may thereupon enter the premises and rooms where said machine or machines are located and take possession of and remove the same at Lessee's expense. (9) Lessee further covenants that all right and interest which under this instrument or by reason of ownership of said machine or machines, patent or patent rights belong to the Lessor shall be deemed to belong to and may be enforced by the Lessor, its successors and assigns, and all covenants and conditions binding upon the Lessee shall be binding upon all successors, assigns or legal representatives of the Lessee. This form of lease may be used for one or more machines, and for a Lessee or Lessees or any number of persons or corporations; where there are a plurality of lessees signing individually or collectively, the signature shall bind all lessees jointly and severally. This lease shall not be valid unless signed by the duly authorized officer of the Lessor. All notices, statements and communications to be given hereunder by Lessee to Lessor shall be given in*784 writing addressed to Lessor's offices at 5520 Second Avenue, Brooklyn, New York. All payments provided herein to be made by Lessee to Lessor shall be in New York funds. *132 WITNESS the signatures and seals of the parties hereto the day and year first above written. Throughout these proceedings the parties call the amount to be paid by the "Lessee" under clause (1) of the contract, upon execution of that instrument, a "deposit" and the entire amount to be paid under that clause the "construction cost." Those terms are used in these findings merely for convenience and are not to be taken as our designation of the true character of the payments to which they refer. At the time the officers and counsel of petitioner were working out the form of contract in conferences with the cigar manufacturers, the latter were told that the American Machine & Foundry Co. would manufacture the cigar machines, and that the petitioner would pay the American Machine & Foundry Co. for the manufacture of them the precise lump sum amounts paid to the petitioner by the cigar manufactures under the contracts. The same representations were made to each cigar manufacturer who entered into a*785 license contract with the petitioner. The deposit made by a cigar manufacturer, upon execution of a license contract, was placed in petitioner's bank account which included the general funds of the company. When the full amount of the construction cost was received by the petitioner, the latter made payment to the American Machine & Foundry Co. for the machines delivered. Never have payments of construction costs by the cigar manufacturer been used for anything other than to pay the American Machine & Foundry Co. for the machines delivered. A considerable number of cigar machines have been transferred by one cigar manufacturer to another cigar manufacturer, and in all instances the consideration for the transfer has been retained by the cigar manufacturer making the transfer of the machine. The following are balance sheets of the petitioner as of December 31, 1918, and 1919: 12/31/18 12/31/19 Assets Cash and accounts receivable $156,541.58 $77,135.27 Good will, patents, patent rights, tools, equipment, etc 10,196,591.95 10,184,946.08 Total 10,353,133.53 10,262,081.35 Liabilities Notes and accounts payable 543,747.67 447,231.65 Reserve for depreciation 145,491.48 167,125.98 Capital stock 10,000,000.00 10,000,000.00 Deficit 336,105.62 352,276.28 Total 10,353,133.53 10,262,081.35 *786 *133 The profit and loss account as per the petitioner's books for the year 1919 is as follows: Gross Income: Royalties on cigar machines $110,443.39 Expenses: Salaries and wages $12,307.63 Interest on loans 15,196.60 Installation and development expenses 57,143.39 Traveling expenses 2,420.00 Trade mark and patent expenses 8,980.47 Corporate taxes 5,283.50 Office and legal expenses 3,938.86 Amortization of patents, etc 21,055.60 126,614.05 Loss for year 16,170.66 During 1919, 238 machines were delivered to users of machines. There was collected from these users $580,400, and the same amount was paid by the petitioner to the American Machine & Foundry Co. in the manner relative to each individual account as hereinafter described. During the same year the petitioner collected as royalties $110,443.39. These royalties, as well as royalties for all subsequent years, have been reported by the petitioner for income tax purposes, but no part of the construction cost of $580,400 was reported for income tax purposes for 1919, nor were any such construction costs in subsequent years reported. The aggregate of such construction costs*787 for the period 1918 to 1928, inclusive, is $11,602,500. During the taxable years involved in these proceedings, the petitioner delivered to users of machines the following numbers of respective machines and received, and paid over to the American Machine & Foundry Co., construction costs in the amounts stated below: Fresh work cigar machines Soft work cigar rolling machines Automatic mold rolling cigar machines Year Number Cost Number Cost Number Cost [386] $1,723,000 [47] $117,500 None [638] 2,852,800 [45] 111,900 [8] $20,000 [210] 938,000 [81] 200,700 None The payments of the foregoing amounts by the users of the machines to the petitioner and by the latter to the American Machine & Foundry Co. were as described hereinafter. The petitioner keeps its books of account on an accrual basis. The deposits and construction costs received by the petitioner from the *134 cigar manufacturers have never been accounted for as income, and the machines purchased from the American Machine & Foundry Co. and turned over under contracts to the cigar manufacturers have not been capitalized, nor has depreciation of*788 the machines ever been accounted for on the books. The detailed method of accounting adopted and followed by the petitioner relative to the transactions in respect to the various types of cigar machines is illustrated by the following transaction and book entries. All such transactions involved in this proceeding were carried out in substantially the same manner. On January 3, 1929, the petitioner entered into a contract with Bayuk Cigars, Inc., for 40 fresh work cigar machines at $4,500 per machine under terms substantially as set forth in the contract quoted above. Relative thereto the following entries appear on the petitioner's books. On January 5, 1929, the petitioner received $40,000 in cash under the terms of the contract, as a deposit on account of the 40 machines. Petitioner deposited the $40,000 in its bank account and "Cash Account" was charged, and an account called "Deposits on Contracts for Cigar Machines" was credited therewith. The petitioner ordered 40 machines to be constructed by the American Machine & Foundry Co. Upon the completion of such construction, the American Machine & Foundry Co. shipped the machines directly to Bayuk Cigars, Inc., and billed*789 the petitioner, in March, April, and May 1929 in the amount of $180,000. Upon receipt of these bills the amounts thereof were credited to "Inter-Company Accounts Payable - American Machine & Foundry Company." On the dates that the bills were rendered by the American Machine & Foundry Co. the petitioner billed Bayuk Cigars, Inc., $180,000 with an accompanying statement indicating a credit of $40,000 for the deposits theretofore received. These bills, totaling $180,000, were charged to "accounts Receivable" (Bayuk Cigars, Inc.) and the deposit of $40,000 was transferred in March, April, and May, by journal entries, from the account "deposits on Contracts for Cigar Machines" to "Accounts Receivable" (Bayuk Cigars, Inc.), by charging $40,000 to "Deposits on Contracts for Cigar Machines" and crediting a similar amount to "Accounts Receivable" (Bayuk Cigars, Inc.). In April and May 1929 Bayuk Cigars, Inc., paid petitioner the balance of the bills rendered in the amount of $140,000. Such amounts were credited by the petitioner to "Accounts Receivable" (Bayuk Cigars, Inc.) and the "Cash Account" was charged with like amounts. During April, May, and June 1929 the petitioner paid amounts*790 totaling $180,000 to the American Machine & Foundry Co. The petitioner charged these amounts to "Inter-Company Accounts Payable - American Machine & Foundry Company", and credited "Cash Account" in like amounts. *135 The construction costs received by the petitioner from the cigar manufacturers have at no time been reflected by the petitioner on any of its income statements or balance sheets published for submission to banks and bankers as a basis for credit rating or loans. In a few cases of bankruptcy the petitioner has taken back cigar machines, but in all instances the fair value of these machines at the time they come into petitioner's possession is included in the profit and loss account on the books, and reported for income tax purposes. From time to time the petitioner has secured approximately 50 additional patents on improvements and attachments to be used on the cigar machines. The "Cross Feed" was patented in 1929 and was added to 99 percent of the cigar machines in the hands of cigar manufacturers. The "Crimper" was patented in 1930 or 1931 and was added to from 40 to 50 percent of the cigar machines in the hands of cigar manufacturers. The average*791 useful life of the cigar machines purchased from the American Machine & Foundry Co. and turned over to cigar manufacturers under license contracts is 12 years. In the petitioner's tax returns for the taxable years under consideration, as well as in the returns for all prior taxable years, net income was computed in accordance with the method of accounting regularly employed in keeping the books of account. The respondent, following examinations and audits by his revenue agents, made no changes in those returns for the taxable years prior to 1929, so far as the method of computing net income is concerned. At no time has the petitioner changed or requested permission to change its method of accounting and computing net income. However, on or about September 19, 1933, the respondent sent a deficiency notice to the petitioner in which deficiencies were proposed for the years 1919 to 1928, inclusive, in the total amount of $1,532,443.68 and penalties of $777,939.00, on the theory that the deposits and construction costs received by the petitioner from the cigar manufacturers in those years constituted taxable income. Under date of November 16, 1933, the respondent advised the petitioner*792 of his redetermination that no deficiencies were due for the aforesaid years, and that the deficiency notice of September 19, 1933, should be disregarded. The statutory period for assessing and collecting any additional taxes for the years 1919 to 1928, inclusive, has expired. In the deficiency notices for the taxable years under consideration, the respondent has treated the deposits and construction costs received from the cigar manufacturers as considerations or bonuses, in addition to the royalties to be received, for the execution of the license contracts and, therefore, taxable income to the petitioner. *136 However, he allowed deductions of $583,424.12 for 1929, $730,294.13 for 1930, and $278,542.09 for 1931, for depreciation of cigar machines in the hands of cigar manufacturers, and further deductions of $130,862.50 for 1929 and $31,666.67 for 1930, for "Loss on machines returned, scrapped, etc." The depreciation deductions so allowed for all three years are based upon a useful life for the machines of 20 years. Also, the said deductions for 1929 and 1930 are based upon the aggregate cost of all machines constructed after 1917, while the deduction for 1930 is based*793 upon the cost of only such machines as were constructed after 1928. The loss deduction allowed for 1929 relates to machines constructed prior to 1929, while the loss deduction allowed for 1930 relates to machines constructed before and after 1929. On December 13 and 14, 1932, relative to the year 1929, and on September 12, 1933, relative to the years 1930 and 1931, the petitioner filed claims for refund with the collector of internal revenue for the first district of New York. These claims were based upon and reflected the respondent's determinations as to, among other things, depreciation allowances and losses in respect of cigar machines, as set forth in the deficiency notices, except that increased depreciation allowances were claimed on the ground that the average useful life of the cigar machines is 14 years, instead of 20 years as determined by the respondent. The petitioner paid income taxes to the collector of internal revenue for the first district of New York for the taxable years under consideration as follows: Date of payment for 1929 Amount Mar. 17, 1930 $59,919.76 June 13, 1930 59,919.76 Sept. 15, 1930 59,919.75 Dec. 15, 1930 59,919.75 Total 239,679.02 Mar. 19, 1931 $65,166.50 June 15, 1931 65,166.50 Sept. 15, 1931 65,166.51 Dec. 16, 1931 65,166.51 Total 260,666.02 Mar. 18, 1932 $58,504.25 June 15, 1932 58,504.24 Sept. 15, 1932 58,504.24 Dec. 15, 1932 58,504.23 Total 234,016.97 *794 Additional facts stipulated by the parties are as follows: 11. In lieu of the amount of $28,185.97 allowed by the respondent in the deficiency notice for the taxable year 1929 on account of franchise taxes paid to the State of New York, the amount of $31,999.61 should be allowed. In the event the Tax Board should sustain the respondent's method of accounting and reporting of income from the aforesaid contracts, in addition to the above New York State franchise taxes, further additional taxes may become payable to the State of New York. In the event of such a decision by the Board, the parties will present computations under Rule 50, relative thereto. It is understood and agreed between the parties that before the said deficiencies, if any, are assessed and collected on the basis of the Board's final orders, the petitioner must produce proof of payment to the said State, and that no claim for refund has been filed or will be filed for said franchise taxes, and if the said proof is not produced *137 the said final orders may be modified at any time to eliminate the said additional franchise taxes. 12. The deficiency notice for the year 1929 allowed depreciation on*795 the cost of patent for the Fresh Work Cigar Machine in the amount of $61,204.19, this being one-seventeenth of development cost of $1,040,471.36 expended prior to March 1, 1913. The patent on the Fresh Work Cigar Machine was issued on April 6, 1915, but application therefor had been filed prior to March 1, 1913. In computing the depreciation for the year 1930 the respondent has allowed only a pro rata part, or $1,145.11, and for the year 1931 the respondent has failed to allow any depreciation on the said patent cost because he has spread the said cost of $1,040,471.36 over a seventeen year period beginning with March 1, 1913, instead of over a seventeen year period beginning with the date the patent was issued on April 6, 1915. 13. In computing depreciation on petitioner's property for the year 1929, the respondent did not allow any deduction for depreciation on certain tools, jigs, dies and patterns purchased during the year 1924 at a total cost of $29,125.14. The correct amount of the depreciation for the year 1929 on this cost is $2,890.01. This amount should be allowed in addition to the amount of $68,345.39, shown on page 2 of the deficiency letter for such year. *796 OPINION. ARUNDELL: The net income determined by the respondent in the deficiency notice for 1929 will be adjusted for depreciation on tools, jigs, dies, and patterns and for additional New York State franchise taxes, in accordance with paragraphs 11 and 13 of the agreed statement of facts set forth in the findings, in the recomputations to be made under Rule 50. The principal issue arises out of the respondent's treatment of the lump sum payments received by the petitioner from cigar manufacturers. The Commissioner in determining the deficiency treated them as advance rentals or bonuses for the use of patents. The petitioner has never treated them on its books or in its returns as income. The petitioner contends that its method of accounting and reporting clearly reflects its income and is in accordance with good accounting practice, whereas the respondent's proposed treatment is not. The petitioner's books have reflected as income from royalties the periodic sums paid to it by the cigar makers based on the number of cigars manufactured and these amounts have been returned as income. Petitioner's books and returns have also carried as income the fair value of the machines*797 repossessed in the few cases of bankruptcy of cigar manufacturers. The immediate question for decision is whether the carrying of these items on petitioner's books correctly reflects the income from the patents or whether there should also be included the lump sum payments in order to clearly reflect income. Section 41 of the Revenue Act of 1928 provides in part as follows: The net income shall be computed * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed *138 does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income * * *. Article 323 of Regulations 74 reads in part as follows: ART. 323. Methods of accounting. - It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. *798 He must, therefore, maintain such accounting records as will enable him to do so. Under similar provisions of other statutes, it has been said that "the method employed by the taxpayer is never conclusive." Brown v. Helvering,291 U.S. 193. On the other hand, it has been said that the requirement that the method of accounting clearly reflect income means only "that the books shall be kept fairly and honestly. * * * In other words, the books are controlling, unless there has been an attempt of some sort to evade the tax." Osterloh v. Lucas, 37 Fed.(2d) 277. There is no question as to what the petitioner has done in this case. It has computed its net income in accordance with the method of accounting regularly employed in keeping its books. Consequently, we have the narrow question of whether that method clearly reflects income. At the outset, we are clearly of the opinion that the lump sum payments are not in the nature of rentals or royalties. Rentals or royalties are paid for the use of property. The lump sum payments here were made for the construction of a capital asset for the use of which royalties were paid. The situation*799 here is somewhat like that in Duffy v. Central Railroad Co.,268 U.S. 55, where the lessee of a railroad under the terms of the lease spent a substantial sum for additions and betterments and construction of a pier. The lessee sought a deduction for such expenditures under the provisions of the 1916 Act which included "rentals" among ordinary and necessary business expenses. The deduction was disallowed, the Court saying: "The term 'rentals', since there is nothing to indicate the contrary, must be taken in its usual and ordinary sense, that is, as implying a fixed sum or property amounting to a fixed sum, to be paid at stated times for the use of property." From the viewpoint of the lessor it is now held that improvements to leased premises made by the lessed currently give rise to income to the lessor only to the extent of either (a) value of the improvements subject to the lease, or (b) an aliquot part of the depreciated value at the expiration of the lease. Emma C. Morphy,35 B.T.A. 289. Applying either of these methods, there is nothing for this petitioner to report, as the useful life of the machines was shorter than the term of the lease. *800 In this case the *139 lessee, that is, the cigar maker, pays for the cost of construction of a machine that he desires to lease on a royalty basis just as the lessee in the realty lease case pays the cost of erecting a building which, with the land, it rents for periodic cash rentals. If in this case the construction costs had been paid by the cigar makers directly to the American Machine & Foundry Co., then clearly, under the principle of the realty lease cases, they would not be income to the petitioner. The substance of the transaction is not changed by having the construction costs pass through petitioner's hands under a system whereby it did not profit from the funds. In all the years of petitioner's operation it has never in fact made a profit from the receipt and disbursement of the lump sum payments. Where there is in fact no profit, the income would be distorted rather than clearly reflected by including in income accounts the non-profit items. Of course, methods of accounting may differ but they may still arrive at the same net income. This is contemplated by both the statute and regulations quoted above. There is testimony in this case by well qualified*801 accounting experts that it might have been proper to treat the lump sum payments as deferred income spread over the life of the contracts and to deduct an equivalent amount annually for depreciation of the machines. The result reflected on the books under that system would be precisely the same as under the petitioner's method. There would be no income reflected for any year or any cycle of years. The advantages of petitioner's method over that of charging on and charging off over a period of years are its simplicity and exactness. Under the other method the accounts would need be carried over a period of years and if the useful life of the machines was not exactly coextensive with the contract period adjustments would need to be made to reflect the difference. The life of the contracts in this case would be difficult to determine in view of the provision that they were to continue in effect during the life of the patents in existence covering the particular machine and further for the life of any additional patents that might be granted on any new parts, attachments, or improvements that might be made or added to the machine. The lives of the contracts have been repeatedly extended*802 by reason of the issuance of new patents. Approximately 50 such patents have been issued to the petitioner. A typical example is that of the "Cross Feed." The patent on the cross feed was issued in 1929 and that improvement was attached to 99 percent of the machines in the hands of cigar makers, thus prolonging the lives of the 99 percent of the contracts beyond the useful life of the machines. Section 41 of the Revenue Act of 1928 quoted above does not require any particular method of accounting. The Commissioner's *140 regulations recognize that no uniform method of accounting can be prescribed for all taxpayers and that the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. We have had occasion to refer with approval to similar provisions of earlier regulations. The one qualification to the broad rule of the regulations is that the method adopted meets the statutory requirement of clearly reflecting income. Ribbon Cliff Fruit Co.,12 B.T.A. 13; *803 H. Stanley Bent,19 B.T.A. 181; affd., 56 Fed.(2d) 99; Alfred E. Badgley,21 B.T.A. 1055; affd., 59 Fed.(2d) 203. Any departure from a method long and consistently followed can be justified only on the ground that it does not clearly reflect income. Bradstreet Co. of Maine,23 B.T.A. 1093; affd., on this point, 65 Fed.(2d) 943. It is our opinion that petitioner's method of accounting for the income from its patents, i.e., by including royalty payments and value of repossessed machines in its income accounts, and excluding from such accounts the lump sum payments made by the cigar makers, does clearly reflect income. We are confirmed in our conclusion on this point by the testimony of the accounting experts who gave it as their opinion that petitioner's method of accounting for the lump sum payments was in accordance with good accounting practice. We do not intend to hold that the method of accounting used by the petitioner is the only correct one, but that the method employed does clearly reflect its income, it has been long and consistently adhered to, and should not therefore be disturbed. *804 It follows from our holding on the above issue that the petitioner is not entitled to depreciation deductions on the cigar machines. The second issue for consideration is the date of the beginning of the 17-year period over which the development cost of the fresh work cigar machine patent is to be amortized and pro rata deductions therefore made in income tax returns. The respondent has held that this period begins on March 1, 1913, since application for the patent was made prior to and was pending on that date, and, accordingly, he has allowed only a proportional deduction of two months for 1930 and none for 1931. However, on the brief, the respondent concedes that the issue is controlled by our decision in Stephens-Adamson Manufacturing Co.,16 B.T.A. 41; affd., 51 Fed.(2d) 681. See, also, Hartford-Fairmont Co.,12 B.T.A. 98; A. e. Starbuck, Administrator,13 B.T.A. 796; and John Douglas Co.,23 B.T.A. 1308. Under those decisions, the 17-year amortization period begins to run from the date the patent was issued, which, in this case, is April 6, 1915. The petitioner, therefore, is entitled to a*805 deduction for each of the years 1930 and 1931 equal to one-seventeenth of the patent development cost. *141 The third issue is pressed by the petitioner only as an alternative to, and in the event of a decision unfavorable to it on, the first issue. We have sustained the petitioner's contention, in our decision on the first issue, that the respondent erred in including the construction costs received from the cigar manufacturers in income. Too, under that holding, the entire costs of the cigar machines are recovered in the years when acquired and delivered to the cigar manufacturers, and there are no remaining costs to be recovered by way of depreciation allowances. Any loss deductions for machines returned and scrapped must be limited to those machines which the petitioner has repossessed and which it has, under its method of accounting, included in income at their fair market value as of the time of repossession. These losses the parties have stipulated may be computed in the recomputations to be made under Rule 50. Reviewed by the Board. Decision will be entered under Rule 50. MURDOCK MURDOCK, concurring: The bookkeeping method which the taxpayer*806 had long and consistently followed clearly reflected its net income. It made its income tax reports in accordance with that method. Thus, there is no occasion to require it to change to some other method which might also clearly reflect its net income. The decision of the case does not require the holdings made in the prevailing opinion that the lump sum payments are not in the nature of rentals or royalties and the inclusion of the lump sum payments in gross income would distort net income. DISNEY concurs in the above. Footnotes 1. Demonstration machines. While this machine was built and patented in 1915, shipments of machines were not made until 1918. ↩