Union Paper Co. v. Commissioner

UNION PAPER CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Union Paper Co. v. Commissioner Docket No. 6402. United States Board of Tax Appeals 9 B.T.A. 1010; 1927 BTA LEXIS 2469; December 31, 1927, Promulgated *2469 Market value of patent application at March 1, 1913, for the purpose of exhaustion of a patent subsequently granted thereon not determinable from the evidence. James D. Williams, Esq., for the petitioner. Granville S. Borden, Esq., for the respondent. SMITH *1010 Deficiencies have been determined for the years 1917 and 1918 in the respective amounts of $8,375.20 and $5,992.37. For each of the years the respondent has denied the petitioner a deduction on account of exhaustion of a patent which was issued March 10, 1914, based upon the claimed value of the patent application at March 1, 1913. FINDINGS OF FACT. The petitioner is a corporation with its principal office at 61 Broadway, New York City. It is and for many years has been engaged *1011 in the manufacture of cylindrical paper boxes and tubes, combination cans and mailing cases. During the years 1917 and 1918 the petitioner was the owner of a patent known as the box machine patent No. 1089619, which was issued March 10, 1914, to Ernest De Neen Anderson, assignor to the petitioner. Application for the patent was filed by Anderson July 9, 1909, and was pending until the*2470 date the patent was issued. Anderson was employed by the petitioner for the purpose of improving and developing new machinery under a continuing contract providing that all inventions made by him during his employment should be the property of the petitioner. The patent application when filed July 9, 1909, contained 41 claims. By a communication from the United States Patent Office, dated September 4, 1909, Anderson was notified that claims 1 to 26, 30 to 32, and 37 were rejected on the United States patent to Cook, 877297, January 21, 1908; that claims 39 and 41 were held not patentable over the British patent to Schonheyder, 1435, April 1, 1881, and that claims 27 to 29, 33 to 36, 38 and 40 might be allowed. Anderson amended his application and was thereafter notified by a communication dated June 22, 1910, that claims 1 to 9, and 11, 19, 20, 27, 29, and 31 were again rejected on Cook; that claim 10 was rejected on Hoyte, et al., 582988, May 18, 1897, and that claims 13, 14, 15, 17, and 18 were rejected on patent to Marsh, 301505, July 8, 1894. By a further communication dated June 24, 1911, Anderson was notified that the application had been considered as amended May 25, 1911, and*2471 that claims 1 and 2 were again rejected upon the patent to Cook; that claim 3 was still believed to be met in the patent to Hoyte; that claims 5, 6, and 7 were not patentable over the patent ot Marsh, and that claim 17, as amended, was allowable. By a further communication dated July 3, 1912, Anderson was notified that upon consideration of the application as amended June 8, 1912, claims 1 and 2 upon the patent to Cook, and claims 4, 5, and 6 upon Marsh were rejected; that while it was true that certain mechanisms of the Cook and Marsh patents differed specifically from the elements employed in applicant's machine, such differences were not pointed out in the claims and that the remaining claims stood allowed. On July 2, 1913, Anderson further amended his application so as to contain 18 claims. Thereafter, these claims were all allowed and on March 10, 1914, the patent was formally issued by the United States Patent Office. The specification of the patent reads in part as follows: To all whom it may concern: Be it known that I, ERNEST DE NEEN ANDERSON, a citizen or the United States of America, residing at New York City, in the county of New York and State of New York, *2472 have invented certain new and useful improvements in Machines *1012 for Making Paper Boxes, of which the following is a specification, reference being had therein to the accompanying drawing. This invention relates to certain new and useful improvements in machines for making boxes or receptacles of various kinds. It is primarily intended for assembling together certain telescoping or interrelated parts of paste-board of other material that have previously been finished by other mechanism to serve in the construction of a box, receptacle, or holder of any kind. * * * The object of the invention is to simplify and perfect the construction of an automatic machine of the class designated, in order that the parts of the boxes that are to be connected together may be rapidly applied to each other and a large number of the desired articles completed with ease in a short time without requiring a skilled operator for the machine, all the care required of the attendant being merely the feeding into the machine of the separate parts and the disposition of the resulting completed boxes, packages, or articles, as they leave the machine. At the close of the year 1912 there were*2473 13 of the box machines installed in the petitioner's plant. One was installed in 1907, six in 1908, two in 1909, three in 1910, and one in 1911. Only minor changes had been made in the mechanism of the machine from the time that the first one was installed in 1907 until the patent was issued. In manufacturing boxes the petitioner used several patented machines other than the box machine here under consideration. The entire process of manufacturing may be briefly described as follows: The paper or box board or whatever material used was first put through a slitting machine where it was cut into small rolls of narrow width. It was then put through a tube rolling machine where the tube was rolled and cut off in rough lengths. From the rolling tube machine it was taken to a cutting machine where it was accurately cut in proper box lengths. Other rolls were taken from the slitting machine to the press room and were run through stamping machines which stamped out the covers for the boxes. The box length tubes and covers were then, prior to the installation of the box machine, taken in baskets to assembling tables where they were put together by hand and the covers fitted on. *2474 After installation of the box machines the process of manufacturing was identical except that the assembling was done automatically. The box machines required two operators, one to place the tubes in position and the other to feed in the covers. The tops when required were fitted on by hand. Girls were generally employed to do the work of assembling and fitting on the tops. The box machines were only used for assembling certain sizes of the small cylindrical boxes measuring up to about 2 inches in diameter and 2 inches in height. The operators of the box machines, as well as those assembling by hand, were paid a certain rate per thousand for the boxes assembled. *1013 Over the four-year period 1909 to 1912 the petitioner's total sales amounted to $1,287,021.85. Of this amount $445,166.53 represented sales of boxes made on the box machines. There were sales of $431,857.13 of snuff boxes made on the machines to three of its customers. The petitioner's total profits for the four-year period as shown by its books of account were as follows: [1909] $14,944.22 [1910] 16,680.92 [1911] 16,653.17 [1912] 15,184.00 Total 63,462.31 The average net tangible*2475 assets for these years amounted to approximately $51,821.35. There were average tangible assets of $131,421.35 and a bonded indebtedness of $79,600. Over the four-month period from January to April, 1913, the petitioner's total sales of machine-made boxes amounted to $37,792.78. For the work of assembling these boxes the machine operators were paid at a rate of 5 1/2 and 6 cents per thousand. For the assembling of the same boxes by hand a rate of 15 cents per thousand would have been paid. On the manufacture of the $37,792.78 of boxes over the four-month period there was a saving in labor cost by use of the box machines of approximately $2,445.27. Substantially the same conditions relative to the comparative costs of assembling by hand and by the box machines existed throughout the years 1909 to 1912, inclusive. The petitioner had been engaged in its present business for more than 20 years prior to 1913. During several years of the latter part of this period it had made a practice of entering in its books in the expense account items of maintenance, renewals and replacements of machinery and equipment. For the four-year period 1909 to 1913 approximately $6,000 of such*2476 items were charged to the expense account. The books further show that for the same period items amounting to $10,969.35, representing expenditures for the development of new machinery, including the box machinery here under consideration, were charged to the expense account. OPINION. SMITH: The petitioner contends that the patent application which it owned on March 1, 1913, and for which the patent was issued by the United States Patent Office the following year, had a definite minimum value at March 1, 1913, of $35,000, and that for each of the taxable years 1917 and 1918 it is entitled to a deduction on account of the exhaustion of the patent equal to one-seventeenth of the March *1014 1, 1913, value of the patent application. The respondent contends that the patent application had no determinable value at March 1, 1913, and that since the patent was acquired by the petitioner subsequent to that date the only basis for the statutory deduction for exhaustion of the patent is its cost to the petitioner and not the March 1, 1913, value of the patent application. In support of its claim for a March 1, 1913, value of $35,000 for the patent application, the petitioner*2477 has shown its earnings over a period of four years next preceding the basic date and has shown the savings and labor cost which resulted to it from the use of the invention in carrying on its manufacturing business. For the four-year period 1909 to 1912 the petitioner's net earnings, as shown by its books of account, were approximately $63,500. The petitioner claims that its net earnings for this period and for several prior years are understated in its books by reason of the fact that many items of maintenance, renewals and replacements of machinery and equipment had been erroneously charged to the expense account, whereas under proper bookkeeping and accounting methods many of such items might have been charged to the capital account. It claims that certain items representing salaries paid to employees engaged in developing new machinery, including the invention here under consideration, which were charged to the expense account should have been charged to the capital account and that certain losses which it sustained during the period and which are reflected in the net income shown in its books were not connected with its regular business and should not be considered in determining*2478 net earnings for the purpose of valuing the patent application. The petitioner has submitted in evidence numerous schedules and computations prepared from its books by accountants showing the result to be reached in determining net income over the four-year period in question by revising the books as indicated and making necessary adjustments for depreciation. Capitalizing the average net earnings over the four-year period at 10 per cent and allowing a fair rate on the average tangibles, the petitioner has determined an average value for the patent application and the other patents used in its business of approximately $110,068.72. Deducting $75,000, which the Commissioner is said to have allowed as the value of other patents, the petitioner has determined a value for the patent application under consideration of approximately $35,000, which it contends is the proper value upon which to base the deduction for exhaustion now sought. The respondent has objected to the materiality of this evidence and contends that the total earnings of the petitioner over such period are not competent evidence to prove the March 1, 1913, value of the patent application. *2479 *1015 The petitioner's contentions that a patent application is property and as such is capable of definite valuation and that the value of the property must be determined by a consideration of all the facts which tend to establish value on the basic date are sound. Individual Towel & Cabinet Service Co.,5 B.T.A. 158. But the earnings of a business in which a patent or an invention is used taken alone are not a criterion of the value of such patent or invention. The fact that the petitioner here had developed an invention which it had used in its business along with other patents in earning substantial profits over a period of years prior to March 1, 1913, certainly does not establish the fair market value of the application for a patent on the invention which was pending on that date. In the cases referred to by the petitioner and others, where we have used prior and subsequent earnings as the basis for determining the value of patents and patent applications at a given date, we have first ascertained that these earnings or a certain part of them were attributable to the particular patent or patent application under consideration and that all of the attending*2480 circumstances supported the value thus determined. We can not determine from the evidence here what part, If any, of the petitioner's earnings over the period 1909 to 1912 may be certainly attributed to the box-machine invention. During these years the petitioner used several other patented inventions each of which performed an important function in its manufacturing process. Assuming that the Commissioner has previously placed an aggregate value of $75,000 upon the other patents used, of which there is no direct evidence before us, still we can not say that such value is a proper basis to be used in allocating the petitioner's earnings to the several patents and inventions used. Moreover, the evidence fairly establishes that te petitioner had good will of a substantial value to which its earnings must in part have been attributable. It has been shown that the box machine performed a necessary function in assembling the boxes and that it did the work more economically than it was done by hand before the machines were brought into use; that by use of the box machines the petitioner was enabled to increase its output of certain types of boxes and perhaps was able to secure and*2481 fill larger contracts for these boxes than it could have without the use of the box machines. We may conclude, therefore, that the box-machine invention was of some value to the petitioner in carrying on its business. We do not know, however, what this value was in terms of dollars or that it had any marketable value whatsoever. It is not shown that there was ever any demand for the invention by other manufacturers of paper boxes. It is not shown that the invention was in any way unique. The *1016 evidence indicates that there were other machines available or capable of performing the same functions. We have no evidence showing the state of the art as it existed on the basic date. Certainly, a reasonably prudent investor would have inquired into these things before purchasing the patent application. Cf. Cheatham Electric Switching Device Co.,1 B.T.A. 984. Upon the evidence we are unable to determine what, if any, was the fair market value at March 1, 1913, of the patent application under consideration, or the cost of the patent when subsequently acquired. It is, therefore, not necessary to consider the question whether exhaustion of the patent for*2482 the years 1917 and 1918 should be computed upon the basis of the March 1, 1913, value of the patent application or the cost of the patent to the petitioner. Judgment will be entered on 15 days' notice, under Rule 50. Considered by TRUSSELL, LOVE, and LITTLETON.