for advertising, capitalized as above indicated, aggregate 33 dollars and the corporation now contends that the capital stock issued against this intangible should be allowed in full as invested capital since the intangible was acquired for cash. It is noted that all of these transactions occurred prior to the year 1909 and the case, therefore, as presented, is not unlike that on which the Committee passed its opinion under Recommendation 115 (not published in bulletin service), March 27, 1920. In that opinion it was said: The Committee is not of the opinion that article 841 of Regulations 45 should be applied in the instant case. This regulation seems obviously to have been drawn for the purpose of preventing the inclusion in surplus or invested capital, for the taxable year 1918, of amounts charged to expenses prior thereto, when the intent was to evade taxation. But such intent in this case is not clear, nor can it even be inferred. Indeed, the facts absolutely prohibit such an inference, for the reason that the transaction by which this restoration to invested capital was accomplished was made effective on the first day of March, 1909, thus conclusively demonstrating the intention of the directors in regard to these expenditures, many years before the income and excess-profits tax law was placed upon the statute books. In the opinion of the Committee, the regulation would be effective to prevent the restoration to invested capital in 1918 of amounts previously charged to expenses, but a careful reading of the regulation renders it exceedingly doubtful that it is subject to so broad a construction that it can, by any possibility, be applied to transactions accomplished and completed before that year. Attention is particularly directed to the last sentence of the regulation quoted above: "An election of this sort which was made concurrently with the transaction can not now be revised, and amended returns in respect thereof can not be accepted." There is no intent on the part of the corporation now to revise an action taken years ago and no attempt has been made to file amended returns. The Committee believes that this reasoning is strengthened by the following quotation from article 843 of Regulations 45: * * Where a corporation has charged to current expenses the cost of developing or protecting patents, no amount in respect thereof expended since January 1, 1909, can be restored in computing invested capital. In respect of expenditures made before January 1, 1909, a corporation now seeking to restore them must be prepared to show to the satisfaction of the Commissioner that all such items are proper capital expenditures. While the opinion just quoted was applicable to the invested capital of a corporation for the taxable year 1918, there is no reason why the same principle should not be applied in determining the invested capital of the M Company for the taxable year 1917. The Committee accordingly is of the opinion that the M Company should be allowed the full amount of 3 dollars, expended by it in cash prior to the year 1909 and capitalized, as a part of the cost of developing certain intangible assets which it had acquired for stock and cash. SECTION 326, ARTICLE 831: Meaning of invested capital. (Also Section 200, Article 1523.) 29-21-1740 T. D. 3183 EXCESS-PROFITS TAX-REVENUE ACT OF 1917-DECISION OF COURT. 1. INVESTED CAPITAL-SECTION 207-EARNED SURPLUS EXPENDED IN IMPROVING INTANGIBLE Asset. Where the earnings of a corporation have been spent in improving a secret chemical process (admitted to be an intangible asset), the increased value of the process due to the improvement effected by such expenditure is to be included in estimating “earned surplus used in the business," as an element of "invested capital," as defined by section 207. 2. SAME. This is also true in a case where the improvement was originally paid for with borrowed money, and where subsequent earnings were sufficiently large to repay the borrowed money and to create before the beginning of the taxable year an "earned surplus." 3. NOMINAL CAPITAL-SECTION 209. Under the facts of this case, a corporation having an earned surplus used in the business, amounting to $2,000, is not "a corporation having no invested capital or not more than a nominal capital," within the meaning of section 209. TREASURY DEPARTMENT, OFFICE OF COMMISSIONER OF INTERNAL REVENUE, To collectors of internal revenue and others concerned: Approved June 24, 1921: A. W. MELLON, D. H. BLAIR, Commissioner of Internal Revenue. Secretary of the Treasury. UNITED STATES DISTRICT COURT, SOUTHERN DISTRICT OF NEW YORK. Lincoln Chemical Co., plaintiff, v. William H. Edwards, as collector, etc. [Apr. 19, 1921.] Action by a taxpayer against the collector for refund of a part of the excess profits tax for 1917. The plaintiff, a domestic corporation, filed its return for 1917 and calculated its capital upon the basis of section 209 of the law of October 3, 1917; that is to say, it assumed that it had "no invested capital or not more than a nominal capital." The Treasury officials reassessed the tax at a larger figure upon a basis not now necessary to set forth, because it is conceded that the propriety of their action depends upon the correctness of the plaintiff's reading of section 209. If that is right, the plaintiff wins; if it is wrong, the defendant. The case was tried before a jury of one and at the conclusion of the evidence both sides moved for the direction of a verdict. The evidence, which was undisputed, showed the following state of facts: The plaintiff was organized in April, 1909, under the laws of New York, with a capital stock of $10,000. There were but two persons financially interested in it, Loeb and Riddle. Riddle was an inventor, and before the incorporation came to Loeb with a process for extracting cocoa butter out of cocoa shells, a by-product. This process proved worthless, and Riddle thereupon suggested to Loeb the possibility of converting the process into one from which he could extract from cocoa shells a chemical substance, known as theobromine, allied to caffeine. Loeb, having some money, continued to advance it in defraying Riddle's further experiments, until he became fearful of too wide involvement, and determined to incorporate the venture. Riddle agreed to work for the corporation for five years at a salary of $1,800 and to convey his process, still unperfected, both for $2,400 par value of the plaintiff's stock. Loeb agreed to convey the machinery and supplies par for par in stock, $7,400, and $200 was paid in cash. During the year 1910 the company borrowed nearly $20,000, which it spent in Riddle's further experiments upon the process which was then complete. During that year it got one, Schaefer, a manufacturing chemist, to make a contract for the exploitation of the process on a royalty basis, but the sales of theobromine were so few that the royalty was never earned. In 1912 they got Schaefer to give them better terms; he agreed to pay $2,000 a year for the process over a period of 15 years and to furnish theobromine to the plaintiff at $2.50 a pound or less. This gave the plaintiff control of a supply without manufacturing. At the time of the first contract in 1910 the plaintiff sold all its machinery and plant to Schaefer for $1,155 and its supplies for $407, and this money was either used in development or upon the indebtedness. In any event, it had all disappeared before 1914. The plaintiff never manufactured any theobromine after 1910. The plaintiff's profits on the sale of theobromine made by Schaefer under the process were not large throughout the year 1911, but they began to increase in 1912 and 1913, and the company thus made a small income besides the royalty paid by Schaefer. The advent of the Great War in 1914 greatly increased the demand, and the business became very profitable, so that by January 1, 1917, all its debts were paid and it had a surplus of $13.000 after writing off a depreciation of $7,700 upon the process. The business was done as follows: There were but three purchasers of theobromine, all large manufacturing chemists, who bought at 10 days cash. The plaintiff necessarily bought all its theobromine (made under the process) from Schaefer at 15 days cash, and was therefore in a position to pay Schaefer out of the moneys which its customers paid to it. As these were of high financial responsibility it had no need to hold a reserve in its treasury in order to finance its purchases, though at times, when in ample funds, it did use its surplus to pay Schaefer before the customers paid for their consignments. During the year 1917 the assets of the plaintiff, therefore, consisted only of its cash on hand, the contract with Schaefer, and the secret process finally perfected by Riddle. Its stock was $10,000, and its surplus, as stated, $13,000, of which over $7.000 was in cash. It necessarily followed that its other assets were valued at $16,000. The case depends upon the meaning of the phrase "invested capital" and "nominal capital" as used in section 209 and as defined in section 207. The plaintiff asserts that there was only $200 of cash paid in, no tangibles remaining after 1913, no surplus" used and employed " in the business, and that the secret process was an "intangible" which must be taken at its "actual cash value" in April, 1909, which is shown to be nothing. The defendant argues that the sums spent upon the process, which did, in fact, increase its value by $19,000, should be taken as a surplus "used and employed" in the business. HAND, District Judge: I shall decide this case upon the assumption that "nominal capital" in section 209 means "nominal invested capital," without of course passing upon that question. I shall further assume-and indeed on this point both sides agree that the secret process of Riddle was "intangible property" within the meaning of section 207(a) (3) (b). I shall finally assume that the process had only a nominal value in April, 1909, when it was sold to the plaintiff for $2.400 of stock. With these assumptions the question arises whether the money used to develop the process can be regarded as “paid in or earned surplus and undivided profits used or employed in the business" under section 209 (a) (3). On the trial I thought that the plaintiff was right on this point, and for clarity I shall therefore state its argument as strongly as I can. The statute, it says, prescribes that "intangible property" of this kind "shall be included in invested capital at a value not to exceed the actual cash value at the time of such purchase." Disregarding "paid-in surplus," of which there is none here, the "earned surplus" is the only item into which the supposed added value of the process can be placed. Now, surplus, or at least "earned surplus" is merely an accountant's way of saying that the value of the assets are greater than the liabilities. When the statute speaks of "invested capital," it must be understood to refer to existing property, i. e.. "means of production," and to use accountant's language, not because accounts can ever of themselves be the basis of taxation, but because they are the most convenient record of actual values, embodied in property which is alone the proper basis of taxation. "Earned surplus" must therefore represent the value of existing property. This being true, continues the plaintiff, the only asset of value in 1917 was the perfected process, and we may assume that it had enough value to give more than a "nominal” “earned surplus" above the capital stock, which was the only liability. Therefore, if the asset could be taken at its true value in 1917, section 209 of the statute would not apply. The difficulty with the collector's position, however, is that section 207 directed us to include the process at no more than its "actual cash value" in 1909, and at that time it had none. The money spent in improving and perfecting the process had, in 1917, no existence at all, save in the process itself. It was spent in machinery or supplies or Riddle's living expenses, or salaries. So far as our treasury was concerned there was nothing now left except the process. That was therefore the only asset which could figure on the credit side of our account to establish any "earned surplus." and the statute forbade its inclusion at anything but a nominal value. Therefore, we had no "earned surplus," and only a "nominal invested capital." This argument appears to me unanswerable if the incompleted process be regarded as the same asset for all purposes when finally developed as when first acquired. The statute must of course mean something, and the least that it can mean must be, I think, that any automatic increase in value of a process or "other intangible property" must be disregarded. "The unearned increment," as economists would call it, will be ignored. Therefore, I should altogether disregard any increase in the value of this process dependent upon general conditions of industry, as for example the rise in the price of theobromine due to the great war. Furthermore, for the purposes of this case anyway, I may assume that an increase in the value of the process, resulting from spending money in advertising or the like, which leaves it unchanged in itself, will fall into the same category. That question can await decision till it arises; I say nothing about it here. The case at bar is, however, one where money has been spent in changing the property itself, so that in place of a formula which prescribed one sequence of steps, there emerged another which prescribed a different sequence. Fair analogies appear to me, for example, cattle fed for market, or houses rebuilt or enlarged. It is true that for convenience we speak of such property as always remaining the same, though in fact it is not only different in value, but that difference results from a change in the objective character of the property itself, but that convenience should not disguise the substantial fact that it is, economically speaking, new property which appears. When such changes have resulted from the expenditure of new capital, I see no reason why the statute should be construed as peremptorily directing that they should be disregarded. It is quite true still, as the plaintiff argues, that the "earned surplus" must be found in some assets and that the only asset in the case at bar still remains the process, but it is a different process. The limitation of section 207 may be contined, without undue violence, to the sense of the words, to such increases in value as arise without the addition of new capital, and it may be to such others also as involve no objective change in the thing itself. Indeed, it can scarcely be supposed that Congress could have had any other purpose than to prevent the taxpayer from crediting his capital account with increases which he had done nothing to produce. If they meant to include also new outlays upon existing capital, no matter how providently made, the statute provides a direct incentive to extravagance. Often, perhaps generally, it is a sound industrial policy to improve existing capital rather than to scrap it and invest anew. Yet if the plaintiff be right no such investment can ever do more than meet depreciation, and this would apply as well to "tangibles" as to "intangibles." The only new values which could be recognized would be in property bought outright after incorporation, and those investments which may have been the means of changing the industrial character and value of existing property would be totally lost for purposes of taxation. When taxes can be as high as the excess profits tax may be, such inducements may become a patent influence upon industrial conduct, and it can not be supposed that the result of the plaintiff's construction was within the purposes of Congress. Again, it should be a weighty consideration with me that the tax bureau has made these allowances in the past in the case of thousands of taxpayers and has drafted its regulations upon the assumption that the statute permits them. I therefore hold that when money has been earned and spent in improving a process such as this, its increased value due only to that expenditure may figure as an asset in estimating under section 207 "earned surplus," if any, as an element of "invested capital." The It does not follow of course in the case at bar that the value of the process so improved was enough to cause any "earned surplus" to emerge. That depends upon whether the assets, so estimated, were greater than the stock, $10,000, by more than a "nominal" amount. Now the value of the "tangibles' must under section 207 be taken as of January 1, 1914, at which time they had disappeared. Therefore, the process must have increased from its nominal value in 1909 to more than $10,000 before any "earned surplus" could begin to appear at all. The value at which the plaintiff carried the process does not definitely appear on its books. On January 1, 1917, it had a surplus of $13,088.59 and therefore assets of $23,088.59. Of this, $7,367.64 was in cash, leaving $15,720.95 for other assets which must be the process and the contract. contract got its value only from the process and may be disregarded. value of the process as of that year would therefore appear to be this sum. This figure, it is true, does not correspond with other evidence and apparently is incorrect. In its income tax return for 1916 it valued the process as of March 1, 1913, at $19,716.84, and claimed a deduction for depreciation to date of $7,761.42, leaving a value of about $12,000 as of January 1, 1917. The discrepancy of some $3,700 I have been unable to account for except upon the hypothesis that there were other assets not shown. Perhaps the cash was greater, because the cashbook showed a balance on January 2, 1917, of $11,000, which just about makes up the difference. Assuming that this is the proper explanation, still on the plaintiff's own admission it had an “earned surplus" of $2,000, which in view of the size of the business I should not consider "nominal" But the defendant was not bound by the plaintiff's admission. It was for the plaintiff to prove that it had only a nominal capital. The process was clearly of very substantial value. The contract had 10 years more to run and there was a minimum royalty of $2,000. Besides this the plaintiff could call for at least 3,000 pounds of theobromine yearly at not more than $2.50 a pound, a right which had been of substantial value in the years before the war began to affect the price. In 1914 this right was worth $525 and the royalty apparently $2,854. Moreover, when the contract terminated the process would not necessarily become worthless. Indeed, it may have a very substantial value for an indefinite time. The plaintiff has certainly failed to prove that its value in 1917 over $10,000 was "not more than nominal." I therefore conclude that the case is not proved and will direct a verdict for the defendant. SECTION 326, ARTICLE 831: Meaning of invested capital. (Also Section 234, Article 564.) 32-21-1765 O. D. 991 In 1920 a corporation increased its capital stock by issuing y additional shares of stock of a par value of dollars per share. Each stockholder registered on the corporation's book at the close of business March, 1920, was given the right to subscribe for one new share of stock for each two shares of old stock held by him on that date upon payment of 2 dollars per share, payable as follows: c dollars on May, 1920, 3x dollars on June, 1920, and a dollars 4x on July, 1920. The company was to pay interest at the rate of 6 per cent per annum on such payments from the date each payment was made. Interest on all payments ceased August, 1920, the date when the certificates were exchanged for the stock of the company. Stock |
