Memorandum Findings of Fact and Opinion
The Commissioner determined deficiencies of $34.78 and $1,845.14 in petitioners' income tax for the calendar years 1965 and 1966, respectively. The only issue remaining for decision is whether amounts received by petitioner, William W. Taylor, in connection with the transfer of certain patent rights should be taxed as capital gain or ordinary income.
Findings of Fact
The parties have stipulated certain facts which, together with the attached exhibits, are incorporated herein by this reference.
Petitioners, William W. and Gene W. Taylor, are husband and wife. They filed joint Federal income tax returns for the calendar years 1965 and 1966 with the district director of internal revenue at Cincinnati, Ohio, and resided in Cincinnati at the time the petition in this case was filed.
During the years 1960 through 1966, William W. Taylor (hereinafter referred to as "petitioner") was engaged in the operation of a sole proprietorship known as The Silent Knight Company, located in Cincinnati. Petitioner owned a United States patent for a manhole cover which he had invented. The patent was to expire on August 29, 1978. He had also applied for Canadian and United Kingdom patents in respect of the same invention. The invention was advertised as "Silent Knight — The Modern Manhole Cover. The first and only truly progressive development in manhole covers in years." A notable feature of the device was its square shape. The frame, which was to be installed at the mouth of the manhole and upon which the manhole lid was to rest, was square, and the lid was formed by two triangular halves, which were joined by iron rods to form a square. The sides of the lid were longer than the diameter of the manhole (to ensure that the lid could not fall through the manhole). As suggested by its name, Silent Knight was advertised as "silent and safe," as well as economical. An advertising leaflet proclaimed: "Silent Knight products are made by foundries, North, South, East and West and sell at freely competitive prices."
The Clare and Angel Agreements
By a "license agreement," dated October 28, 1959, between petitioner, doing business as the Silent Knight Company (identified therein as "Licensor") and Clare Brothers Ltd. of Preston, Ontario, Canada (identified therein as "Licensee"), petitioner transferred certain interests in his "inventions."
Petitioner agreed to furnish Clare Brothers all blueprints and other information prepared by it for the manufacture of the inventions and to make available to it for a "reasonable length of time" certain master patterns and master gages for use in production. In addition to a stated consideration of $1.00 Clare Brothers agreed to pay the petitioner
The agreement also provided for a minimum annual "royalty" of $250, effective in 1961. In addition, Clare Brothers acknowledged the validity of any patent issued as the result of petitioner's application and agreed that it would not, directly or indirectly, dispute or attack the validity of such patent. The agreement also recited that petitioner was the owner of an application for registration of the trademark "Silent Knight" in Canada, and Clare Brothers agreed to acknowledge petitioner's ownership of the trademark and the registration therefor, when granted. The following provision was made with regard to assignments:
Petitioner entered into a second "license agreement," dated August 17, 1960, with Angel Manufacturing and Supply Company, Ltd. ("Angel") of North Sydney, Nova Scotia, Canada. It was similar to the 1959 agreement with Clare Brothers but differed from that instrument in the following respects. The "license" granted to Angel was, at least in part, geographically restricted to Canada's Maritime Provinces and was termed "non-exclusive":
Unlike Clare Brothers, Angel was given the option to cancel the agreement on three months' notice at any time after three years from the date of the agreement. Finally, the Angel agreement did not include a counterpart to the covenant made in the Clare agreement whereby petitioner promised that during the existence of the agreement he would not grant the right to use the trademark "Silent Knight" on goods manufactured within the assigned territory. In all other respects, however, the two instruments were substantially identical.
The record does not disclose whether or not, prior to the dates of the Clare and Angel agreements, petitioner had entered into arrangements with other manufacturers
The Broads Agreements
On October 22, 1960, petitioner doing business as the Silent Knight Company and Broads Manufacturing Company Ltd. of London ("Broads") entered into an agreement transferring certain rights in petitioner's manhole cover. The instrument (entitled "Deed") recited that petitioner (identified therein and in subsequent supplemental "deeds" as "the owner") owned a United States patent, that he had lodged a provisional application for a grant of letters patent for the United Kingdom, and that he had agreed to grant to Broads (identified therein and in supplemental "deeds" as "the licensee") "an exclusive license to manufacture, sell and distribute the said manhole cover in the United Kingdom * * *." The instrument provided in part as follows:
Clause 4 provided that if Broads exercised the option to extend the agreement:
Once extended beyond the initial one-year period, the agreement could be terminated in the following manner:
In addition, petitioner covenanted to give Broads all the information and assistance at its disposal to facilitate manufacture and sale of the manhole cover and promised that, during the continuation of the agreement, he would not manufacture, sell, or distribute the manhole cover within the United Kingdom or grant a license to do so without the written consent of Broads. Broads made the following covenants:
On March 8, 1962, petitioner and Broads executed a supplemental "deed." That instrument recited that unforseen delays had prevented an initial survey of the project from being completed within one year of the date of the original agreement and that Broads should have exercised the option to extend the license beyond one year. Under the terms of the supplemental "deed," petitioner granted Broads an "exclusive license and authority to manufacture sell and distribute the manhole cover" from October 22, 1961 (the date on which the one-year term of the original agreement expired) until June 30, 1962, with an option to extend the license:
On October 17, 1962, petitioner and Broads entered into a third "deed," varying the terms of the original instrument (identified therein as "the Original Deed") as modified by the supplemental "deed" (identified therein as "the Second Deed"). It provided in part as follows:
Petitioner subsequently obtained patents for his invention from the United Kingdom and Canada. They were to expire, respectively, on June 20, 1977, and July 18, 1978.
Between 1962 and the end of 1966, petitioner received annual payments from Broads pursuant to their agreements. Such payments were at times in excess of the minimum amounts called for by the agreements. During this period Broads undertook the construction of a foundry, designed primarily to manufacture the manhole covers governed by its agreements with petitioner. The cost of the foundry was approximately three million pounds.
During the years 1965 and 1966, petitioner received the following amounts as a result of the agreements with Clare Brothers, Angel, and Broads:
Payor 1965 1966 Clare Brothers, Ltd. $ 244.71 $ 603.87 Angel Manufacturing & Supply Co., Ltd. ............. 602.16 1,784.55 Broads Manufacturing Co., Ltd. ........ 3,308.69 10,918.98
During 1965 and 1966, petitioner also received annual payments, generally ranging in size from about $100 to approximately $700, from five other enterprises as the result of agreements similar to those described.
On their Federal income tax return for 1965, petitioners reported the payments received in 1965 in connection with the three agreements summarized above as ordinary income. However, within the time prescribed by law, petitioners filed an amended return for 1965 seeking a refund of income tax allegedly erroneously paid as a result of reporting the payments as ordinary income rather than as long-term capital gain. On their 1966 return, petitioners reported the payments received in that year as long-term capital gain. In his statutory notice of deficiency to petitioners, the Commissioner disallowed certain deductions for real estate and personal property taxes which petitioners had claimed on their 1965 return. He also determined that the payments received in 1966 in connection with the agreements described above were taxable in that year as ordinary income rather than as long-term capital gain.
Petitioners have conceded the correctness of the Commissioner's disallowance of the deduction for the claimed real estate and personal property taxes.
The question presented is whether petitioner and his wife are entitled to treat as long-term capital gain the payments received from Clare Brothers, Angel, and Broads in 1965 and 1966 in return for the transfer of certain rights in petitioner's manhole cover. Petitioners' claim for capital gain treatment of the proceeds of the three transactions in issue is based primarily upon section 1235, I. R. C. 1954. Section 1235(a) provides:
SEC. 1235. SALE OR EXCHANGE OF PATENTS.
The parties appear to agree that even though petitioner had not obtained patents from the United Kingdom and Canada at the time the original agreements were executed, the payments in question were made in return for "rights to a patent." See Franklin S. Speicher [Dec. 22,519], 28 T.C. 938, 944-945, acq. 1958-2 C. B. 7. Nor do the parties dispute that petitioner, the inventor of the manhole cover, qualifies as a "holder," as that term is defined by section 1235(b).
Whether there has been a transfer of "all substantial rights" in respect of the Clare, Angel and Broads transactions depends in each situation upon an appraisal of all the evidence relating to that situation. Cf. Joe L. Schmitt, Jr. [Dec. 22,983], 30 T.C. 322, 331, affirmed [59-2 USTC ¶ 9718] 271 F.2d 301 (C. A. 9). And the evidence must be evaluated in the light of petitioner's burden of proof to establish that there has been a transfer of "all substantial rights." Upon a review of the record before us, we have concluded (1) that petitioner has failed to prove that there was such a transfer in the case of the Clare and Angel agreements and (2) that he has established the existence of such a transfer in respect of the Broads agreements.
1. The Clare and Angel Agreements. We note at the outset that the agreements were drafted as "licenses," that the parties were identified therein as "licensor" and "licensee," and that the periodic payments were termed "royalties." Although the use of this terminology indicates a license arrangement rather than a completed assignment or sale, such language, while of some weight, is not controlling. We must look to the substance of what the parties have put together. Oak Manufacturing Co. v. United States, [62-1 USTC ¶ 9388], 301 F.2d 259, 261-262 (C. A. 7); Merck & Co. v. Smith [58-2 USTC ¶ 9959], 261 F.2d 162, 164 (C. A. 3); Schmitt v. Commissioner [59-2 USTC ¶ 9718], 271 F.2d 301, 305 (C. A. 9), affirming [Dec. 22,983] 30 T.C. 322; Watson v. United States [55-1 USTC ¶ 9455], 222 F.2d 689, 691 (C. A. 10); William S. Rouverol [Dec. 26,748], 42 T.C. 186, 193, nonacq. 1965-2 C. B. 7; cf. Waterman v. MacKenzie, 138 U.S. 252, 256. "[T]he entire transaction, regardless of formalities, should be examined in its factual context to determine whether or not substantially all rights of the owner in the patent property have been released to the transferee, rather than recognizing less relevant verbal touchstones." S. Rept. No. 1622, 83d Cong., 2d Sess. p. 440 (1954); cf. Rose Marie Reid [Dec. 21,806], 26 T.C. 622, 632, acq. 1956-2 C. B. 8.
The Commissioner has pointed to a number of features of the Clare and Angel agreements which, in his judgment, disqualify the payments made pursuant to them from capital gain treatment. He has emphasized that the rights conferred by the agreements were both non-assignable and geographically limited and that neither agreement specified the grantee's right to sue in its own name for patent infringement. There is substantial doubt whether these factors alone would suffice to deny petitioners capital gain treatment. Compare Waterman v. MacKenzie, 138 U.S. 252, 256-261; Regs. section 1.1235-2(b)(1)(i); Oak Manufacturing Co. v. United States [62-1 USTC ¶ 9388], 301 F.2d 259, 262 (C. A. 7); Schmitt v. Commissioner [59-2 USTC ¶ 9718], 271 F.2d 301, 307 (C. A. 9), affirming [Dec. 22,983] 30 T.C. 322, 332-334, with Allen v. Werner [51-2 USTC ¶ 9398], 190 F.2d 840, 842 (C. A. 5); Vincent B. Rodgers [Dec. 29,482], 51 T.C. 927, 928-932; Merck & Co., v. Smith [58-2 USTC ¶ 9959], 261 F.2d 162, 165 (C. A. 3); William S. Rouverol [Dec. 26,748], 42 T.C. 186, 193-194, nonacq. 1965-2 C. B. 7. These factors are nevertheless part of the total picture which may not be ignored. And other aspects of that total picture support the Commissioner's determination.
It has generally been considered necessary to transfer the exclusive right to manufacture, sell, and use patented property in order
Under the Clare agreement petitioner granted a "non-assignable, indivisible license" in respect of his invention
Plainly, only the right to manufacture was explicitly described as "exclusive." In sharp contrast, the right to use and sell was not thus fixed. We think the difference is crucial, and may not be brushed aside merely because, in a following paragraph, petitioner covenanted that he would not make any agreement with a "distributor" regarding the distribution of manhole covers, etc., within Ontario without first obtaining Clare's permission. It is by no means clear what the word "distributor" means in this context — i.e., whether it encompasses any seller (such as a retailer or a wholesaler), or whether it is limited to a more narrow class of dealer in manufactured goods or commodities. And in view of the fact that the word "exclusive" was employed only in respect of manufacture, the inference is strong that the provisions in the later paragraph were intended to refer only to certain types of sellers. Moreover, there still remains a tenable construction of these provisions to the effect that petitioner had not given up his own right personally to sell or use within Ontario. The matter in any event is entirely too murky for us to conclude that petitioner had parted completely with the right to use and sell in Ontario, and since the burden was on him we cannot find that he had transferred "all substantial rights."
The Government's position in respect of the Angel agreement is even stronger. The grant of rights to manufacture, use, and sell was expressly termed "non-exclusive." As in the Clare agreement, petitioner promised only to refrain from licensing other manufacturers and "distributors" while the agreement remained in effect. The result follows a fortiori from the conclusion that we reached as to the Clare agreement.
In their brief, petitioners suggest that law other than that codified in section 1235 may authorize capital gain treatment of the payments in issue. Petitioners cited no authority, statutory or otherwise, for this proposition, and did not argue the point. In any event, in Myron C. Poole [Dec. 28,002], 46 T.C. 392, 404, we rejected such a contention:
We think that our decision in Poole disposes of petitioners' suggestion here. Cf. Thomson v. United States [70-1 USTC ¶ 9193], 25 AFTR 2d 70-697, 703-706 (E. D. N. Y.); Leonard Coplan [Dec. 22,574], 28 T.C. 1189, 1192, acq. 1958-2 C. B. 4; Herbert C. Johnson [Dec. 23,047], 30 T.C. 675, 682, acq. 1958-2 C. E. 6.
2. The Broads Agreements. We think that, by virtue of his three agreements with Broads, petitioner did transfer all substantial rights to the manhole cover, and that payments received pursuant to those agreements
The Commissioner notes that the original "deed" was granted for only a one-year term, and asserts that neither of the two supplemental deeds varied the one-year provision. It has been held that a grant of rights to a patent which terminates before the expiration of the remaining life of the patent does not amount to a "sale" of patent rights. See Oak Manufacturing Co., v. United States [62-1 USTC ¶ 9388], 301 F.2d 259, 263 (C. A. 7); Jacques R. Milberg [Dec. 29,597], 52 T.C. 315, 317, Regs. section 1.1235-2(b)(1)(ii). Here the first instrument gave to Broads an exclusive license to manufacture, sell and distribute for one year, plus an option to extend the agreement until terminated in accordance with clauses 4(v) or 4(vi). The first supplemental agreement reaffirmed the terms of the original agreement and extended the term of the license for eight additional months, until June 30, 1962. The second supplemental agreement, dated October 17, 1962, did not expressly state that the option had been exercised. However, the agreement related only to clause 4 of the original agreement, which applied only if the option had been exercised. Furthermore, Broads continued to make annual payments to petitioner between 1962 and 1966, which were required only if the agreement had been extended pursuant to the option given to Broads. We conclude that as of October 17, 1962, the parties understood that the option had been exercised and that the agreement had been extended beyond the initial period. After that time the agreement could be terminated only in accordance with clauses 4(v) and 4(vi) of the agreement, as modified. These clauses permitted termination only if Broads' royalty payments were in arrears, if Broads violated its covenants under the agreement, or if Broads elected to terminate the agreement and gave six months' written notice of its intention to do so. The resulting possibility in these circumstances that the agreement might terminate prior to the expiration of the life of the patent is not sufficiently significant to deny treatment of the transaction as a sale. See Merck & Co. v. Smith [58-2 USTC ¶ 9959], 261 F.2d 162, 164-165 (C. A. 3); Allen v. Werner [51-2 USTC ¶ 9398], 190 F.2d 840, 842 (C. A. 5); Watson v. United States [55-1 USTC ¶ 9455], 222 F.2d 689, 691 (C. A. 10); William S. Rouverol, supra, 42 T.C. 186, 194; Roy J. Champayne, supra, 26 T.C. 634, 638, 640; Lamar v. Granger [51-2 USTC ¶ 9386], 99 F.Supp. 17, 38 (W. D. Pa.).
The Commissioner also contends that Broads was not given the right to use the patented invention and that petitioner's retention of such right precludes treatment of the transaction as a sale. In this respect, the Commissioner relies upon Regs. section 1.1235-2(b)(3)(ii) which provides that retention of the right to use a patent "may or may not" constitute a substantial right. Although the agreements did not include the word "use", they did grant Broads a license to "manufacture sell and distribute" the manhole cover. We think that the agreements, together with the surrounding circumstances, reveal that a complete assignment of all substantial rights was intended and consummated. See Rose Marie Reid, supra, 26 T.C. 622, 633; Franklin S. Speicher, supra, 28 T.C. 938, 943-944. Moreover, even were the right to "use" the manhole cover not granted by implication, we are quite doubtful that retention of the right to "use" the manhole cover (other than by manufacturing or selling it) is a meaningful or substantial right. Cf. Werner v. Allen [50-1 USTC ¶ 9251], 42 AFTR 1166, 1172 (M. D. Ga.), affirmed [51-2 USTC ¶ 9398] 190 F.2d 840 (C. A. 5).
The Commissioner points out that petitioner also retained the right to manufacture, sell, and distribute the manhole cover in the United Kingdom and the right to license others to do so, subject to the consent of Broads. However, since both of the foregoing rights were contingent upon the consent of Broads, they obviously do not constitute substantial rights in the patented property. The Commissioner also contends that since the agreements prevented Broads from assigning its license or sublicensing under it without petitioner's consent, petitioner's power to prohibit such assignments constituted retention of a substantial right. Although there is some support for the Commissioner's position,
The Commissioner asserts that under the agreements, petitioner controlled the prosecution of patent infringement suits and that this amounted to retention of a substantial right in the patented property. We disagree. It is not at all clear that petitioner retained the power to control all of such suits. The original agreement stated only that where the owner so requested, Broads would "institute or join with the owner in any proceedings" relating to the patent. In any event, provisions determining the party to bring infringement suits are generally considered "procedural" in nature and not significant enough to deny treatment as a sale. See William S. Rouverol, supra, 42 T.C. 186, 193-194; Merck & Co. v. Smith [58-2 USTC ¶ 9959], 261 F.2d 162, 165 (C. A. 3). Compare Oak Manufacturing Co. v. United States [62-1 USTC ¶ 9388], 301 F.2d 259, 262 (C. A. 7); Schmitt v. Commissioner [59-2 USTC ¶ 9718], 271 F.2d 301, 307 (C. A. 9), affirming [Dec. 22,983] 30 T.C. 322.
Finally, the Commissioner emphasizes that Broads was denied the right to export the manhole cover. The agreements granted manufacturing and distribution rights within the United Kingdom only. However, in Vincent B. Rodgers [Dec. 29,482], 51 T.C. 927, we held a more restrictive geographical limitation to be insufficient to defeat treatment as a sale. There the transferee's rights were limited to an area within the borders of the nation issuing the patent. Here, where the manufacturing and distributing rights granted to Broads were coextensive with the territory of the United Kingdom, the nation issuing the patent, our reasoning in Rodgers applies a fortiori.
Even when considered together, the factors stressed by the Commissioner do not warrant treatment of the Broads transaction as a licensing arrangement rather than as a sale or assignment. Such rights as petitioner retained are simply not sufficiently significant interests to amount to one or more "substantial rights" in the patented property as that term has been interpreted in the decided cases.
Decision will be entered under Rule 50.
* * *
(b) "Holder" Defined. — For purposes of this section, the term "holder" means —
(1) any individual whose efforts created such property, or
(2) any other individual who has acquired his interest in such property in exchange for consideration in money or money's worth paid to such creator prior to actual reduction to practice of the invention covered by the patent, if such individual is neither —
(A) the employer of such creator, nor
(B) related to such creator (within the meaning of subsection (d)).
We are aware that sec. 1.1235-1(b), Income Tax Regs., provides that if sec. 1235 does not apply because a transfer is made to a related person, the tax consequences of the transfer are to be determined under other provisions of law. If that section of the regulations is intended to imply that when a holder transfers a patent and receives payments in the manner described in sec. 1235(a), such payments may qualify for capital gains treatment, the regulations must yield to the contrary legislative purpose.