1 The following cases are consolidated herewith for purposes

of trial, briefing, and opinion: Victor I. Podd, docket No.

20226-93; Victor T. Podd, docket No. 20227-93; Powertex, Inc.,

docket No. 20228-93; Powertex, Inc., docket No. 20229-93;

Powertex, Inc., docket No. 6209-94; Victor T. Podd, docket No.

6210-94; Victor I. Podd, docket No. 6211-94; Stephen D. Podd,

docket No. 6212-94; Julia Podd, docket No. 6213-94; and Powertex,

Inc., docket No. 6214-94.

T.C. Memo. 1998-231

UNITED STATES TAX COURT

STEPHEN D. PODD, ET AL.,1 Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 20225-93, 20226-93, Filed June 30, 1998.

 20227-93, 20228-93,

 20229-93, 6209-94,

 6210-94, 6211-94,

 6212-94, 6213-94,

 6214-94.

Kevin M. Flynn and Julian W. Dority, for petitioners.

John Aletta, Elise Frost Alair, and Bradford A. Johnson, for

respondent.
- 2 -

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge: Respondent determined deficiencies, additions

to tax, and penalties in petitioners' Federal income taxes as

follows:

Stephen D. Podd, docket Nos. 20225-93, 6212-94:

Penalties 

Year Deficiency Sec. 6662(a)

1988 $463 -

1989 12,654 $2,530.80

1990 61,674 12,335.00

Victor I. Podd, docket Nos. 20226-93, 6211-94:

Penalties 

Year Deficiency Sec. 6662(a)

1988 $951 - 

1989 12,065 $2,413

1990 135,094 27,019

Victor T. Podd, docket Nos. 20227-93, 6210-94:

 Additions to Tax Penalties 

Year Deficiency Sec. 6653(a)(1) Sec. 6661 Sec. 6662(a)

1988 $48,402 $2,402 $12,101 -

1989 475,634 - - $95,127

1990 68,637 - - 13,727

Julia Podd, docket No. 6213-94:

Penalties 

Year Deficiency Sec. 6662(a)

1990 $52,277 $10,455

Powertex, Inc., docket Nos. 20228-93, 6214-94:

Tax

Year Additions to Tax Under Section Penalties

Ended Deficiency 6653(a)(1)(A) 6653(a)(1)(B) 6653(a) 6661 6662(a) 
- 3 -

2 The increased deficiencies result from respondent's

assertion of additional constructive dividends to the individual

petitioners which, correspondingly, results in increased

additions to tax and penalties. Specifically, respondent amended

his answers to assert that certain payments deducted as

management fees paid by Powertex, Inc. to Powertex Plus

International, Inc. resulted in constructive dividends. The

amendments to answer assert such constructive dividends against

several of the individual petitioners in addition to those

against whom constructive dividends were determined in the

notices of deficiency. The amendments to answer also raise an

alternative argument that if these payments are not constructive

dividends, they should be characterized as compensation income to

the individual petitioners.

Respondent also amended his answers with respect to certain

royalty payments that respondent determined were not ordinary and

necessary business expenses pursuant to sec. 162. In the notices

of deficiency, respondent's alternative position was that the

royalty rate should be adjusted, pursuant to sec. 482, to 5

percent. By way of amended answers, respondent asserts that the

(continued...)

5/31/88 $89,534 $6,570 

1 - $32,850 - 

5/31/89 311,413 - - $17,869 89,345 - 

5/31/90 514,390 - - - - $102,878

 

150 percent of the interest due on $148,814.

Respondent determined deficiencies in, additions to tax, and

penalties in, Powertex, Inc.'s withholding tax as follows:

Powertex, Inc., docket Nos. 20229-93, 6209-94:

Tax

Year Additions to Tax Under Section Penalties 

Ended Deficiency 6651 6653(a) 6653(a)(1)(A) 6653(a)(1)(B) 6656 6661 Sec. 6662(a)

5/31/85 - - - - - 167 - -

5/31/86 $412,425 $103,776.50 - $20,621.25 1 41,510.60 $103,106.25 -

5/31/87 - - - - - 136 - -

5/31/88 48,206 12,454 $2,410.30 - - 4,981.60 12,051.50 -

5/31/89 487,975 - - - - 50,106.90 - $100,213.80

5/31/90 245,882 - - - - 24,588 - 49,176

150 percent of the interest due on the deficiency.

Pursuant to amended answers, respondent asserts increased

deficiencies, additions to tax, and penalties in petitioners'

Federal income taxes.2
- 4 -

2(...continued)

appropriate royalty rate pursuant to sec. 482 should be 0

percent. Correspondingly, respondent amended his answers to

increase the constructive dividends asserted against several of

the individual petitioners.

Respondent bears the burden of proof with respect to the

increased deficiencies, additions to tax, and penalties pleaded

in the amended answers. Rule 142(a). In light of our holdings

with regard to the issues raised in the amended answers, however,

the location of the burden of proof is immaterial.

3 Petitioners conceded several issues in the stipulations of

facts. Additionally, to the extent they did not address other

issues on brief, we consider such issues to have been conceded. 

Rybak v. Commissioner, 91 T.C. 524, 566 n.19 (1988).

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

STATEMENT OF ISSUES

After concessions,3 the issues remaining for decision are: 

1. Whether petitioner Powertex, Inc., is entitled to deduct

certain royalty payments paid to certain individual petitioners, or

whether an adjustment under section 162 or section 482 is warranted;

2. whether consulting fees paid by Powertex, Inc., to Special

Commodities Services, Inc., are ordinary and necessary business

expenses deductible under section 162;

3. whether amounts deducted by Powertex, Inc., as management

fees paid to Powertex Plus International, Inc., are reasonable

payments for services rendered;

4. whether the individual petitioners received constructive

dividends; 
- 5 -

5. whether petitioner Victor I. Podd was a resident of the

United States during 1990; and

6. whether petitioners are liable for certain additions to tax

and penalties as determined by respondent.

For convenience and clarity, we have divided our opinion into

separate segments. The first segment sets forth general findings of

fact applicable to all of the issues in the instant case. Each of

the segments following our general findings of fact discusses one of

the separate issues set forth above and sets forth our findings of

fact and opinion concerning the respective issue.

I. General Findings of Fact

 Some of the facts have been stipulated for trial pursuant to

Rule 91. The stipulations of facts are incorporated herein by

reference, and they are found accordingly.

At the time its petition was filed, in the instant case,

Powertex, Inc. (Powertex) was a New York corporation. Powertex's

principal corporate office was located at Rouses Point, New York. 

At the time they filed their petitions in the instant case,

petitioners Victor T. and Julia Podd resided in Mount Royal, Quebec,

Canada; petitioner Stephen D. Podd resided in North Hero, Vermont;

and petitioner Victor I. Podd resided in Boca Raton, Florida.

A. Founding of Powertex

Powertex was incorporated under the laws of the state of

Vermont in 1977 by petitioner Victor T. Podd (Mr. Podd), his wife

petitioner Julia Podd (Mrs. Podd), and his brother Alexander Podd.
- 6 -

The original name of the corporation was Powerstrap, Inc., which was

subsequently changed to Powertex Corporation, Inc., in 1979 and

finally to Powertex, Inc., in 1984. Powertex was initially formed

to be a packaging manufacturer. Powertex began its business

operations in Alburg, Vermont, on property owned by Mr. Podd. In

1984, Powertex expanded its business from the Alburg facility to a

new manufacturing plant in Rouses Point, New York.

From 1977 through 1992, Mr. Podd was the president, chief

executive officer and largest shareholder of Powertex, and Mrs. Podd

was its corporate secretary and treasurer. From 1983 through 1990,

their children, Victor I. Podd (Victor, Jr.), and Stephen D. Podd

(Stephen), served as vice presidents of Powertex. From 1977 through

1990, all of the outstanding stock in Powertex was owned by Mr.

Podd, Victor, Jr., Stephen, and Mrs. Podd. From 1977 through 1990,

Mr. Podd and his two sons (collectively, the Podds) and Mrs. Podd

were Canadian citizens.

Today, Powertex is a manufacturer of several products used in

the shipping industry. The core products sold by Powertex are

intermodal container liner systems, used to transport such dry bulk

flowable products as rice, corn, sugar, carbon black, and PVC

resins. Intermodal cargo containers come in either 20-, 35-, or 40-

foot lengths, and can carry up to 24 tons of cargo. An intermodal

container liner is a plastic liner placed inside a shipping

container for the purpose of protecting the contents from loss and

contamination during shipment and to prevent corrosion of the
- 7 -

container itself. Essentially, the liner is a large plastic bag

which conforms to the interior dimensions of the intermodal

container. The liner is attached to a bulkhead which acts as a

sidewall and holds the cargo in the container, and which contains a

portal through which the cargo is loaded and unloaded. After

installation and inflation of the liner system inside the container,

cargo can then be conveyed into the container. The container is

then transported by rail, truck, or ship. 

Powertex currently manufacturers three principal types of

intermodal container liner systems.

B. The Hideliner

One of Powertex’s earliest products consisted of an intermodal

container liner system known as the hideliner. During the 1970's,

Mr. Podd became acquainted with several employees of Sea-Land

Service, Inc., (Sea-Land), a company engaged in the commercial

transportation business. Sea-Land shipped raw green animal hides

packed in salt. The hides released contaminating fluids which,

combined with the salt, had a caustic effect on the containers in

which they were shipped. In response to this problem, Mr. Podd

developed the hideliner (also known as the powerliner) to be used

for shipping raw green animal hides. 

Essentially, the hideliner consists of a base sheet of foam

material and a top cover sheet of polymeric material which is bonded

to the base sheet, and which extends over at least a portion of the
- 8 -

walls of the container. As designed, it constitutes a liquid

impervious liner useful in the transportation of raw animal skins. 

Mr. Podd filed a patent application for the hideliner with the

U.S. Patent and Trademark Office on August 1, 1978. On February 5,

1980, the U.S. Patent and Trademark Office issued United States

Patent No. 4,186,845 (the '845 patent) covering the hideliner

invention.

On May 21, 1980, Mr. Podd licensed to Powertex the exclusive

right to manufacture, market, and sell the hideliner. The terms of

the agreement granted Powertex an exclusive 6-year license in

exchange for royalties of 5 percent during the initial six-year term

of the license and 7 1⁄2 percent during any extensions of the license.

The license agreement was renewed on November 30, 1985, for an

additional 6-year term.

C. The Sea Bulk Liner

On October 26, 1970, and February 9, 1972, Bert A. Bodenheimer,

an employee of Sea-Land, filed patent applications for what would

eventually come to be known as the Sea Bulk container liner system. 

United States patent numbers 3,696,952 and 3,868,042 (collectively,

the Sea Bulk patents) were issued on October 10, 1972, and February

25, 1975, respectively, as a result of these applications. These

patents were subsequently assigned to Sea-Land by Mr. Bodenheimer.

The Sea Bulk liner system was designed for use in shipping products

in dry bulk form and also protects products against contamination

and seepage during transport. 
- 9 -

During the 1970's and through May 1983, Sea-Land licensed the

exclusive rights to manufacture, market, and sell products covered

by the Sea Bulk patents to Tri-Wall Containers (Tri-Wall). The

terms of the license agreement provided that Tri-Wall would pay

royalties to Sea-Land at an initial rate of 8 percent of net sales

of Sea Bulk liners for the first year of the agreement, 9 percent

for the second year, and 10 percent thereafter.

In March 1981, Raymond Stopper founded Insta-Bulk, Inc.,

(Insta-Bulk) in Houston, Texas. Insta-Bulk, like Powertex, was

engaged in the business of manufacturing and selling intermodal

container liners for use in the transportation industry. During

1982, a dispute developed between Insta-Bulk, Sea-Land, and Tri-Wall

concerning whether Insta-Bulk was manufacturing and selling liners

which infringed upon the Sea Bulk patents. During 1982, Insta-Bulk

filed a request for declaratory judgment with the United States

District Court in New York alleging that the Sea Bulk patents were

invalid and unenforceable and that it was not infringing upon the

Sea Bulk patents. Sea-Land and Tri-Wall counterclaimed for damages

resulting from Insta-Bulk’s alleged disclosure of Tri-Wall’s trade

secrets and for infringement of the Sea Bulk patents by Insta-Bulk. 

Sea-Land eventually became dissatisfied with Tri-Wall’s

performance and therefore terminated its license agreement during or

around May 1983. On May 5, 1983, Powertex entered into an exclusive

license agreement with Sea-Land for use of the Sea Bulk patents

(Sea-Land license agreement). The Sea-Land license agreement
- 10 -

required, for all Sea Bulk liners sold within the ocean container

industry, that Powertex pay Sea-Land a royalty of 10 percent of net

sales of Sea Bulk liners, and expend a minimum of 10 percent of net

sales of Sea Bulk liners for the purpose of marketing, advertising,

and promotion of Sea Bulk liners. For Sea Bulk liners sold outside

the ocean container industry, Powertex was required to pay Sea-Land

a royalty of $10 for every Sea Bulk liner sold, and to expend $10

for each unit sold for the purpose of research and development of

markets outside of the ocean container industry. The Sea-Land

license agreement was amended on January 17, 1985, to provide that

Powertex would pay royalties quarterly at the rate of 10 percent for

the first 5,000 Sea Bulk liners sold, 7 1⁄2 percent for the next

2,500, and 5 percent for all units over 7,500. On February 21,

1986, the agreement was again amended, this time to provide that

Powertex would pay royalties quarterly at the rate of 5 percent of

net sales of Sea Bulk liners.

On May 26, 1983, Powertex entered into a sublicense agreement

with Insta-Bulk for use of the Sea Bulk patents. The agreement

allowed Insta-Bulk to manufacture, market, and sell liners covered

by the Sea Bulk patents in Louisiana and Texas. The agreement

provided that Insta-Bulk would pay royalties to Powertex at the rate

of 18 percent of net sales of Sea Bulk liners for use in the ocean

container industry for the first year, and at the rate of 20 percent

of net sales thereafter. For liners sold for use outside of the

ocean container industry, Insta-Bulk was required to pay Powertex
- 11 -

$20 for each Sea Bulk liner sold. On May 27, 1983, Insta-Bulk and

Sea-Land settled their litigation, with Insta-Bulk agreeing to the

validity and enforceability of the Sea Bulk patents and to

infringement of one or more of the claims of the patents. Effective

January 1, 1989, the royalty rate for the Insta-Bulk sublicense was

reduced to 13 percent. On March 15, 1991, Powertex terminated its

sublicense agreement with Insta-Bulk. 

D. The Amoco-Style Liner

During mid-1985, Gene Rakar of Amoco Chemical Company (Amoco)

approached Mr. Podd concerning the feasibility of using intermodal

container liners to transport pure terephthalic acid (PTA), a fine,

white powder used to make polyester fiber. In the fall of 1985, Mr.

Podd invited Mr. Rakar, Frank Hall (Amoco's Marketing Product

Manager), and Tracy Sommer (an engineer at Amoco) to observe a test

loading of a Sea Bulk liner at General Electric, a Powertex

customer, in Selkirk, New York. After witnessing the demonstration,

the Amoco personnel determined that the Sea Bulk liner was not

acceptable for shipping PTA, due to the 2 to 3 hour loading time,

which needed to be shortened to approximately 15 minutes. 

Additionally, Amoco needed a liner that was moisture sensitive and

utilized a center discharge opening in order to be compatible with

their customers' unloading equipment. A short time later, Amoco

employees visited another Powertex customer in New Orleans to

witness another loading demonstration. 
- 12 -

Initial testing of the Sea Bulk liner supplied by Powertex

began in late 1985 and early 1986 at Amoco's Cooper River plant. 

The Powertex plant at Rouses Point, New York, manufactured the test

liner. Mr. Podd worked closely with Mr. Rakar, Mr. Sommer, and Mr.

Hall in testing and modifying the liner in order to meet Amoco's

needs. Initially, the Sea Bulk liner was modified by providing a

center discharge opening in order to fit the unloading equipment of

Amoco's customers. The liner was inadequate for unloading PTA,

however, due to its poor flow characteristics, which resulted in the

product's gathering in the corners and tearing of the liner when

discharging. In order to remedy the problem, Amoco hired

contractors to install wooden triangles in the rear corners of the

container by nailing them to the bracing attached to the container

walls and floor. 

During early 1986, Amoco asked Powertex to develop a liner and

bulkhead compatible with Amoco's loading and unloading equipment and

to modify the liner bulkheads to display the words "Amoco" and

"PTA". On January 3, 1986, and March 5, 1986, Mr. Sommer sent

letters to Powertex recommending changes in the dimensions for the

inlet and outlet openings located in the liner bulkhead. From March

1986, through the following several months, Amoco and Powertex

personnel continued to test and modify the liner. During that

period, the liner was modified by attaching the triangles to the

rear bulkhead. The size and dimensions of the triangles were

subsequently modified to facilitate the discharge of the PTA. 
- 13 -

On April 22, 1986, Mr. Podd, as president of Powertex, wrote to

Attorney Kenneth L. King of the law firm Scully, Scott, Murphy &

Presser in Garden City, New York, to request that the firm represent

him and Powertex in filing patent applications for the inventions

resulting from the modifications which had been made to the Sea Bulk

liner in order to ship PTA. 

During June 1986, further changes were made to the liner based

upon tests conducted at Amoco's Belgian plant, which included

improving the triangular diagonals to ensure that the liner fell

into place against the walls and floor of the container, installing

bungee cords on the sides of the liner, and adding bracing at the

rear bulkhead to prevent it from bulging upon discharge. 

During July 1986, Powertex supplied Amoco with 2 or 3 modified

liners which were loaded with PTA and shipped to Amoco's customers

in Taiwan. Upon unloading, however, the liners completely failed,

resulting in total loss of the PTA shipment. During July and August

of 1986, several modified liners supplied by Powertex were loaded

with PTA and shipped to Amoco's customers in Hong Kong and Taiwan. 

Those liners also failed to unload properly, however, because

several hundred pounds of PTA remained inside the container. 

In response to such problems, the liner was modified by (1)

changing the angles of the triangles to allow the PTA to more easily

flow out upon unloading; (2) removing the front bulkhead and

replacing it with a wooden nailing strip laminated to the liner; (3)

adding "shake-out straps" to assist in removing the PTA; and (4)
- 14 -

separating the liner from the bulkhead, thereby allowing the

triangles to function without tearing the liner when the PTA was

unloaded. Mr. Sommer and other Amoco engineers worked closely with

Powertex in determining the proper size and shape of the triangles. 

On October 16, 1986, Mr. Podd filed a patent application with

the U.S. Patent and Trademark Office for an intermodal container

liner system, the key features of which include a prefabricated,

collapsible bulkhead that is easily installed in an intermodal

container. Another important feature is the provision for hinged,

triangular corner members designed to funnel the cargo towards a

center discharge opening, thus preventing the product from gathering

in the corners of the container upon unloading.

During late 1986, Amoco increased its purchases of the modified

liner as the initial testing had been completed. During November

1986, Powertex shipped liners to Amoco's Belgian plant for testing. 

Amoco was not satisfied with those liners because they employed

cardboard triangles which bowed under the weight of the product,

thereby leaving approximately 150 pounds of PTA in the liner

corners. After that test, additional improvements were made to the

liner to meet the needs of Amoco's customers, including modifying

the bracing system, outlet spout, and size and slope of the

triangles. During August 1987, Amoco chose Powertex as its sole

source of intermodal container liners because (1) Powertex and Amoco

had developed a good working relationship; (2) Powertex sold its

liners at a reasonable price; and (3) Powertex had agreed to build a
- 15 -

facility near Amoco's Cooper River plant, thus ensuring an

alternative supply source should production become impaired at the

Rouses Point facility. 

During March 1988, Amoco and Powertex discussed entering into a

purchasing agreement for Amoco's liner requirements and the opening

of a second manufacturing facility near Amoco's Cooper River plant. 

On February 22, 1989, Powertex and Amoco executed a blanket purchase

agreement. In the agreement, Amoco agreed to purchase liners for

its Cooper River plant exclusively from Powertex during the 2-year

period commencing January 1, 1989. The agreement was renewable by

Amoco for four 1-year periods, provided estimates of Amoco's 1989

liner requirements, set forth guaranteed prices, and imposed

manufacturing specifications. The agreement also allowed Powertex

to supply Amoco with liners at the end of the initial 2-year period

at matching prices, if a competitor offered to sell non-infringing

liners at lower prices. 

During 1990, the Podds incorporated Powertex South Carolina

(Powertex SC) in Moncks Corner, South Carolina, which began

manufacturing liners for Amoco's Cooper River plant in April of

1990. Eventually, Powertex SC came to sell 50 percent of the liners

it manufactured to customers throughout the world. Powertex SC did

not pay any royalties to the Podds or Powertex for its sale of the

Amoco liners. 

On September 27, 1988, Mr. Podd filed a patent application with

the U.S. Patent and Trademark Office for certain improvements on the
- 16 -

4 Petitioners contend that applications for foreign

counterpart patents were filed by Powertex because at that time

Canada was not a signatory to the Patent Cooperation Treaty, and,

therefore, Mr. Podd could not file for such patents, but

Powertex, a United States corporation, could.

5 It is not clear from the record why Powertex, rather than

Mr. Podd, brought suit against Insta-Bulk, nor is the period in

time when this suit took place disclosed in the record. 

October 16, 1986, application. Although Amoco made several

suggestions and requests during the developmental stages of the

liner system, Amoco did not assert any ownership rights in the

invention. On January 24, 1989, and December 5, 1989, United States

Patent numbers 4,799,607 and 4,884,722, respectively, (the Amoco

patents) were issued to Mr. Podd by the U.S. Patent and Trademark

Office for the invention.

Subsequently, Powertex filed applications in several countries

for foreign counterpart patents concerning the Amoco liner, listing

Mr. Podd as the inventor.4 Several foreign counterpart patents were

subsequently published as a result of the applications. 

Powertex paid the legal expenses and filing fees for both the

U.S. and foreign counterpart patents concerning the Amoco liner. On

its corporate tax returns, the expenses and fees were either claimed

as deductions or capitalized. 

Powertex sued Insta-Bulk for infringement of the Amoco

patents.5 On December 22, 1994, in settlement of the litigation, an

agreement was executed which provided that Powertex would grant

Insta-Bulk a "limited, exclusive, non-transferrable license" to make
- 17 -

and sell to Union Carbide Corporation intermodal bulk container

liners using the Amoco patents and their foreign counterparts. In

exchange for such license, Insta-Bulk agreed to pay a royalty of 11

percent of the gross sales of such liners. The agreement also

provided that Powertex is granted a "limited, exclusive, nontransferrable license" to make and sell to Amoco intermodal bulk

container liners having inflatable air corner bags using patents

owned by Raymond Stopper of Insta-Bulk. In exchange for such

license, Powertex agreed to pay a royalty of 11 percent of the gross

sales of such liners. 

E. The Tri-Podd License Agreement

During late 1986, sales of Amoco liners became an increasingly

significant portion of Powertex's total sales, with net profit

margins for these sales increasing to 50 percent by 1989. Sales of

Amoco liners accounted for the following percentages of Powertex's

overall business:

Fiscal Percentage of

Year Total Sales

1986 <1

1987 40

1988 69

1989 68

1990 60

Sales of Amoco liners contributed to significantly increased profits

for Powertex, as shown below:
- 18 -

Fiscal Net Taxable

Year Income

1985 $1,290,536

1986 1,351,033

1987 1,701,787

1988 4,335,176

1989 6,739,962

1990 7,174,522

During February 1988, Mr. Podd discussed with his accountant,

Ronald R. Plante of Peat Marwick, the possibility of licensing the

Amoco patents to Powertex. The discussion was motivated in part by

the increasing amounts of taxable income that Powertex was expected

to earn from the increased sales of Amoco liners. In May 1989, at

the end of Powertex's fiscal year, Mr. Podd and Mr. Plante again

discussed licensing the Amoco patents to Powertex and set the

royalty rate at 15 percent of net sales of Amoco liners.

Powertex did not make any royalty payments for use of the Amoco

patents during the fiscal years ending May 31, 1986, through May 31,

1988. On its Federal corporate income tax returns for the fiscal

years ending May 31, 1989, and May 31, 1990, Powertex reported

paying royalties of $686,034 and $531,082, respectively. On May 30,

1989, and May 30, 1990, Powertex issued checks to Mr. Podd in the

amounts of $617,430.26 and $477,973.35, respectively. Such amounts

represented the amounts deducted by Powertex for royalties on its

Federal corporate income tax returns, less a 10-percent withholding

tax payment. Each of the Podds reported one third of the amount
- 19 -

which Powertex deducted as royalty expenses as royalty income on

their individual Federal income tax returns (Forms 1040NR). 

Powertex created a ledger entitled "Royalties Payable to Victor

T. Podd" in order to keep track of the royalties payable on sales of

the Amoco liners. On September 27, 1990, respondent mailed an audit

letter to Powertex indicating that its 1989 Federal income tax

return was being audited. After respondent's audit had begun,

Powertex changed the ledger's title to "Royalties Payable to Victor

T. Podd, Victor I. Podd and Stephen D. Podd" and provided a copy to

respondent. 

During 1990, Mr. Podd and Mr. Plante began drafting a licensing

agreement for the Amoco patents, using the Sea-Land agreement as a

model. A written license agreement was not executed, however, until

after respondent's audit had begun. During late December of 1990 or

January of 1991, the Podds, individually, and Mrs. Podd, as

secretary of Powertex, executed a document entitled "Tri-Podd

License Agreement" which was dated "as of May 23, 1988". At the

same time, the parties executed an amendment to that document dated

"as of May 24, 1989". Subsequently, a second amendment to this

agreement dated "as of May 29, 1990" was drafted and executed. 

The Tri-Podd License Agreement provided for royalty payments to

the Podds of 15 percent of Powertex's net sales of Amoco liners in

exchange for the right to use the Amoco patents. The agreement's

term was 6 years, commencing June 1, 1988, and renewable by Powertex
- 20 -

if it sold at least 5,000 Amoco liners in fiscal year 1993. The

agreement further provided:

Podd hereby grants to Powertex, for the full term of

this Agreement and any extension thereof, the sole and

exclusive right and license to manufacture, market and

sell AMOCO STYLE units and any and all other devices,

methods and processes covered by the patents and patent

applications listed in the attached Exhibit A. Said right

and license shall be world-wide in scope and shall include

the right to use and enjoy said patent rights and permit

others to use and enjoy said patent rights, including the

marketing and sale of AMOCO STYLE units for uses outside

of the ocean container industry. 

Under the agreement, the Podds also granted a license to

Powertex for the exclusive worldwide right to use the trademark

"POWERLINER" in connection with products covered by the licensed

patents without an additional royalty. 

Powertex also agreed to assume financial responsibility to the

extent of $50,000 per year, commencing on June 1, 1988, for costs

incurred by the Podds or Powertex in defending and litigating patent

infringement claims. The agreement provided that it would be

construed and governed by New York Law. The agreement failed to

identify the patents covered. The only reference to specific

patents was contained in the following clause:

(c) Powertex may terminate this Agreement as of the

tenth day following the sending of a notice of such

termination to Podd if any court of competent jurisdiction

of last resort shall render a final adjudication holding

that the AMOCO STYLE United Stated [sic] Patents (numbers

4,799,607 and 4,884,722) are invalid. 
- 21 -

The agreement indicated that the specific patents covered were

contained in Exhibit A. Exhibit A, however, was not created until

1996, and was first provided to respondent during March 1996. 

The first amendment to the agreement, effective June 1, 1989,

reduced the royalty rate to 12 1⁄2 percent and obligated Powertex to

assume full financial responsibility for the costs of defending and

litigating patent infringement claims. The second amendment to the

agreement required the Podds to disclose improvements or further

inventions embodying the ideas covered by the licensed property to

Powertex, and if the improvements were dominated by the licensed

patents, the Podds would disclose to Powertex the method of making

and using the improvements and allow it to make, use, and sell

products containing such improvements royalty free. The amendment

also allowed the Podds to apply for patents concerning the

improvements in other countries at Powertex's expense and

discretion. 

II. Issue 1: Whether Powertex Is Entitled To Deduct Royalty

Payments, or Whether an Adjustment Under Section 162 or Section

482 Is Warranted

FINDINGS OF FACT

1. Respondent's Notices of Deficiency

In the notices of deficiency, respondent disallowed deductions

claimed by Powertex for royalty expenses on its Federal income tax

returns for the years ending May 31, 1989, and May 31, 1990, in the

amounts of $686,034 and $531,082, respectively. Respondent

determined that such amounts were not ordinary and necessary
- 22 -

business expenses under section 162 or were not expended for the

purpose designated. Alternatively, respondent determined that Mr.

Podd did not engage in the Amoco patent transactions between himself

and Powertex at arm's length, and, accordingly, respondent made

adjustments pursuant to section 482. Respondent initially

determined an alternative adjustment under section 482 using a 5-

percent royalty rate, resulting in a disallowance of royalty

expenses claimed for the years ending May 31, 1989, and May 31,

1990, in the amounts of $457,356 and $318,649, respectively. 

Respondent's answer was amended to assert an arm's-length royalty

rate pursuant to section 482 of 0 percent. 

2. The Experts’ Positions

a. Respondent’s Experts

i. Joel E. Lutzker

Mr. Lutzker received his B.A. in physics from New York

University and his J.D. from New York University School of Law. He

has been active in the fields of patents, trademarks, and copyrights

for 20 years and is currently a partner in the intellectual property

law firm of Amster, Rothstein & Ebenstein. 

Mr. Lutzker's reports examined the ownership of the Amoco

patents and their validity and enforceability. Mr. Lutzker began by

examining several different theories under which Powertex could be

found to have an ownership interest in the patents. He explained

that under the "corporate opportunity" doctrine, the fiduciary

responsibility of a corporate officer to act in the corporation's
- 23 -

best interests could create an obligation to assign a patent. Such

an obligation could also arise under the "alter ego" theory where

the corporate officer completely dominates the affairs of the

corporation. A corporation could also derive an ownership interest

where there is an implied contractual relationship for the

inventor/employee to assign an interest in a patent to the

corporation. Additionally, when an employee is specifically hired

to devote his efforts to a particular problem, any invention that

results from the performance of that work belongs to the employer

pursuant to the "hired to invent" doctrine. Finally, although not

as strong as an actual ownership interest, a corporation that has

gained "shop rights" in an invention is entitled to a royalty-free,

nonexclusive license to practice the invention; i.e., where an

employee conceives and perfects an invention during the hours of

employment, working with the employer's materials and appliances.

After examining the relevant facts, Mr. Lutzker determined that

Powertex owned the Amoco patents because of the obligations of the

Podds as corporate officers, because the Podds agreed to assign the

patents, and because the Podds were hired to invent. Alternatively,

Mr. Lutzker determined that Powertex at least had shop rights in the

patents which allowed it to use the patents without paying any

royalties.

Turning to the issues of validity and enforceability, Mr.

Lutzker explained that a patent is invalid if the claimed invention

is not new or it is obvious in light of the knowledge in the
- 24 -

technical art which existed at the time that the claimed invention

was conceived. He also stated that a patent will be unenforceable

where the patent applicant has engaged in inequitable conduct before

the U.S. Patent and Trademark Office; i.e., where the applicant

breaches the duty of candor and good faith by failing to disclose

all material information concerning the patentability of the

invention.

After examining the circumstances surrounding the issuance of

the Amoco patents, Mr. Lutzker concluded that there was "strong

evidence" that both patents were unenforceable due to Mr. Podd's

failure to disclose material prior art to the U.S. Patent and

Trademark Office. He further concluded that a "strong argument"

could be made that both patents were invalid because certain prior

art renders each claim of the patents obvious.

ii. Robert Goldscheider

Mr. Goldscheider received his B.S. in economics from Columbia

University in 1951 and his J.D. from Harvard Law School in 1954. He

has more than 35 years of experience in the licensing field and is a

frequent lecturer on problems involving the transfer and

commercialization of technology. 

Mr. Goldscheider's expert report and his rebuttal report were

limited to the issue of a reasonable royalty rate for a license of

the Amoco patents. He indicated that the issues of "patentability

and enforceability" of the patents were outside the scope of his
- 25 -

expertise and that he would therefore rely on Mr. Lutzker's reports

as to those issues.

Essentially, Mr. Goldscheider adopted Mr. Lutzker's conclusions

that the Amoco patents were invalid and unenforceable and that

Powertex owned or at least had shop rights in such patents. He

determined that, due to such factors, Powertex received nothing of

value pursuant to the Tri-Podd license agreement and that the

appropriate royalty rate should be zero percent. As an alternative

position, Mr. Goldscheider determined that a 2-percent royalty may

be reasonable. He arrived at that figure by starting with the 5-

percent royalty rate he determined was applicable under the SeaLand/Powertex license of the Sea Bulk patents as of May 23, 1988. 

He then described a hypothetical noninfringing alternative to the

Amoco liner and reasoned that, because the Amoco patents could be

easily circumvented by such an alternative, the royalty rate should

be less than half of the 5-percent rate applicable under the SeaLand/Powertex license of the Sea Bulk patents.

b. Petitioner’s Experts

i. Donald S. Chisum

Professor Chisum currently teaches at Santa Clara University

School of Law. From 1969 through 1996, he was a member of the

faculty at the University of Washington School of Law. Since 1970,

he has regularly written and lectured on the subject of intellectual

property and patent law, and he is the sole author of a multiple

volume reference treatise, Patents: A Treatise on the Law of
- 26 -

Patentability, Validity and Infringement. He is also "of counsel"

to the law firm of Morrison & Foerster in San Francisco. 

Professor Chisum's expert report and his rebuttal report were

limited to the issue of the ownership of the Amoco patents, as

between Powertex and Mr. Podd. Professor Chisum began his analysis

with the general proposition that the actual human inventor owns the

patent rights to an invention until those rights are transferred. 

He stated that there are several exceptions to the general rule,

including an express or implied contract to assign patent rights,

the "hired to invent" doctrine, the "corporate opportunity"

doctrine, the "alter ego" theory, and the "shop right" doctrine.

Professor Chisum examined the legal framework underpinning each

of the exceptions to the general rule. He determined that none of

the exceptions apply to give Powertex an ownership interest in the

Amoco patents. Accordingly, Professor Chisum concluded that Mr.

Podd has been the legal and equitable owner of the Amoco patents at

all times and that any rights Powertex has in those patents derive

solely from the Tri-Podd license agreement.

ii. Gayle Parker

Mr. Parker received his B.S. in industrial engineering from

Lafayette College in 1956 and his J.D. from George Washington

University in 1960. From 1956 to 1957, he worked as a patent

examiner in the U.S. Patent and Trademark Office. From 1958 to

1979, he was the Director of Licensing and patent counsel for the

National Aeronautics and Space Administration Headquarters. Since
- 27 -

1979, he has been the president of Technology Licensing Corporation

and "of counsel" to a patent law firm, Larson & Taylor, in

Arlington, Virginia. 

Mr. Parker's expert report and his rebuttal report were limited

to examining the reasonableness of the royalties paid pursuant to

the Tri-Podd license agreement. Mr. Parker began by analyzing the

relevant factors identified in section 1.482-2(d)(2)(iii), Income

Tax Regs. He determined that under the Tri-Podd license agreement,

Powertex received "a can't lose, practically risk free, patent

protected, competitive [sic] free, fully developed, commercially

successful and a higher priced, high profit product together with a

built-in, ready to purchase, large consumption customer." He

concluded that a "high royalty" was warranted.

Mr. Parker calculated a reasonable rate by hypothesizing that

the parties to a licensing agreement would initially determine a

starting value for the royalty rate. The approach he used to

determine the starting value was (1) to evaluate the royalty with

reference to rates for similar patents in similar circumstances, and

(2) to treat the royalty as a direct function of forecasted profits

to be derived from the sale of Amoco liners.

Under the first approach, Mr. Parker considered the

Powertex/Sea-Land license regarding the Sea Bulk patents and the

Powertex/Insta-Bulk sublicense regarding the Sea Bulk patents to be

comparable to the Amoco patents. He concluded, however, that the

Tri-Podd license agreement gave many special advantages not found in
- 28 -

the license agreements regarding the Sea Bulk patents, and,

therefore, a "much higher royalty" was justified.

Under the second approach, the parties to the license agreement

would determine a royalty rate by determining a reasonable division

of profits anticipated through exploitation of the licensed

technology. Mr. Parker noted that, because a licensee typically

assumes greater financial risk in commercializing technology, a

conservative rule of thumb in royalty negotiations allocates 25

percent of the anticipated profits to the licensor. Mr. Parker

noted, however, that such percentage can be negotiated upward or

downward, and, because Mr. Podd brought a "strong arsenal of assets"

to the licensing negotiations, he could demand a royalty rate which

would entitle him to 50 to 75 percent of the anticipated profits. 

Mr. Parker used such an allocation of profits to determine that Mr.

Podd was entitled to royalties in the range of 15.3 to 23.0 percent

and that a royalty rate in the range of 12.5 to 15 percent is

"definitely reasonable." In using the allocation of profits to

determine a reasonable royalty rate, however, Mr. Parker used

actual, rather than projected, sales data in his calculations.

iii. George M. Thomas

Mr. Thomas received his B.S. in mechanical engineering from the

University of South Carolina in 1957 and his L.L.B. from the

American University Law School in 1964. From 1960 to 1964, he

worked as a patent examiner in the United States Patent Office in

Washington, D.C. Since 1964, he has been continuously engaged in
- 29 -

the practice of patent, trademark, and copyright law. He is

currently the senior partner in the firm of Thomas, Kayden,

Horstemeyer & Risley in Atlanta, Georgia. 

Mr. Thomas prepared two expert witness reports (first and

supplemental) which addressed the validity and enforceability of the

Amoco patents, and the reasonableness of the royalties paid pursuant

to the Tri-Podd license agreement. 

Mr. Thomas began his analysis of the validity of the Amoco

patents by noting that patent applications are subject to a rigorous

examination process performed by a patent examiner trained in the

particular technical field to which the patent application is

directed. He noted that an issued patent is presumed to be valid

and that one who challenges validity must prove by clear and

convincing evidence that the patent is invalid. Mr. Thomas then

performed a detailed analysis of each claim of the Amoco patents,

and, after comparison to other patents issued for intermodal

container liners, concluded that both patents were valid.

Next, Mr. Thomas analyzed the enforceability of the patents. 

He noted that, because of the ex parte nature of a patent

application, a patent applicant has a duty to act with candor, good

faith, and honesty in dealing with the U.S. Patent and Trademark

Office and must disclose all prior art known to the applicant which

is material to the patent application. If that duty is breached, a

patent may be held unenforceable because of the inequitable conduct. 

In order to prove such inequitable conduct, one challenging a patent
- 30 -

must prove (1) materiality of prior art, (2) knowledge by the patent

applicant of prior art and its materiality, and (3) failure to

disclose the prior art to the U.S. Patent and Trademark Office with

intent to mislead or deceive. Applying the foregoing standard to

the facts of the instant case, Mr. Thomas concluded that the Amoco

patents could not be held unenforceable for inequitable conduct.

Finally, Mr. Thomas calculated a royalty rate applicable to the

licensing of the Amoco patents. He began by stating that the

license of the Amoco patents to Insta-Bulk in settlement of the

litigation with Powertex was evidence of what a reasonable royalty

would be in an arm's-length transaction. He then determined that a

higher royalty rate was justified under the Tri-Podd license

agreement because the rights granted therein did not restrict sales

to a single customer and because of the provision including all

improvement patents developed by the Podds.

Rather than analyzing the relevant factors identified in

section 1.482-2(d)(2)(iii), Income Tax Regs., Mr. Thomas next

proceeded to analyze 15 factors set forth in Georgia-Pacific Corp.

v. U.S. Plywood Corp., 318 F.Supp. 1116, 1120 (S.D.N.Y. 1970),

modified 446 F.2d 295 (2d Cir. 1971), which dealt with determination

of the amount of a reasonable royalty to be paid by an infringer to

the patent holder. Based on his analysis of such factors, he

concluded that Mr. Podd could command a royalty in an arm's-length

transaction of "greater than the 11% royalty for the restricted

license of Insta-Bulk, probably 15%".
- 31 -

6 Sec. 482 provides as follows: 

In any case of two or more organizations, trades, or 

businesses (whether or not incorporated, whether or not 

organized in the United States, and whether or not 

affiliated) owned or controlled directly or indirectly by 

the same interests, the Secretary may distribute, apportion,

or allocate gross income, deductions, credits, or allowances

between or among such organizations, trades, or businesses, 

if he determines that such distribution, apportionment, or 

allocation is necessary in order to prevent evasion of taxes

or clearly to reflect the income of any of such 

organizations, trades, or businesses. In the case of any 

transfer (or license) of intangible property (within the 

meaning of section 936(h)(3)(B)), the income with respect to

such transfer or license shall be commensurate with the 

income attributable to the intangible.

OPINION

1. Analysis of Arm’s-Length Royalties for Use of 

 Intangibles

a. Section 482 in General

Section 4826 gives respondent broad authority to allocate

income, deductions, credits, or allowances between commonly

controlled organizations, trades, or businesses if respondent

determines that the reallocation is necessary to prevent the evasion

of taxes or clearly to reflect the income of the controlled

entities. The purpose of section 482 is to prevent the artificial

shifting of the net incomes of controlled taxpayers by placing

controlled taxpayers on par with uncontrolled, unrelated taxpayers. 

Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102 T.C. 149,

163 (1994); Sundstrand Corp. v. Commissioner, 96 T.C. 226, 352-353

(1991); see also Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525,

581 (1989), affd. 933 F.2d 1084 (2d Cir. 1991); Edwards v.
- 32 -

7 In the instant case, petitioners thus bear the burden of

proving that respondent's downward adjustment of the royalty

rate, pursuant to sec. 482, to 5 percent in the notices of

deficiency is arbitrary, capricious, or unreasonable. Because

respondent amended his answers to assert that the appropriate

royalty rate, pursuant to sec. 482, should be 0 percent, the

burden of proving that the royalty rate should be adjusted below

5 percent rests with respondent. Rule 142(a); see also supra

note 2.

Commissioner, 67 T.C. 224, 230 (1976); sec. 1.482-1(b)(1), Income

Tax Regs.

The Commissioner's authority to make allocations under section

482 is broad. Edwards v. Commissioner, supra at 230; PPG Indus.,

Inc. v. Commissioner, 55 T.C. 928, 990-991 (1970). The

Commissioner's section 482 determination must be sustained absent a

showing that he has abused his discretion. Paccar, Inc. v.

Commissioner, 85 T.C. 754, 787 (1985), affd. 849 F.2d 393 (9th Cir.

1988). Consequently, the taxpayer bears the heavier than normal

burden of proving that the Commissioner's section 482 allocations

are arbitrary, capricious, or unreasonable.7 Your Host, Inc. v.

Commissioner, 489 F.2d 957, 960 (2d Cir. 1973), affg. 58 T.C. 10, 23

(1972); Seagate Tech., Inc. & Consol. Subs. v. Commissioner, supra

at 164; G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 359 (1987). 

Whether the Commissioner's discretion has been exceeded is a

question of fact. American Terrazzo Strip Co., Inc. v.

Commissioner, 56 T.C. 961, 971 (1971). In reviewing the

reasonableness of the Commissioner's allocation under section 482,

we focus on the reasonableness of the result, not the details of the
- 33 -

methodology employed. Bausch & Lomb, Inc. v. Commissioner, supra at

582; see also Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372

F.2d 990, 997 (1967).

In addition to proving that the deficiencies set forth in the

notice of deficiency are arbitrary, capricious, or unreasonable, the

taxpayer has the burden of proving satisfaction of the arm's-length

standard. See Sundstrand Corp. v. Commissioner, supra at 354.

b. The Regulations in General

Section 1.482-2(d), Income Tax Regs., provides a framework for

determining an arm's-length consideration for the transfer, sale,

assignment or loan of intangible property or an interest therein

between members of a group of controlled entities. Section

1.482-2(d)(3)(ii)(a), Income Tax Regs., specifically identifies

"patents" as intangible property. Accordingly, we shall apply

section 1.482-2(d), Income Tax Regs., in making our inquiry as to an

arm's-length consideration for the rights Powertex received under

the Tri-Podd license agreement.

An arm's-length consideration is defined specifically as "the

amount that would have been paid by an unrelated party for the same

intangible property under the same circumstances." Sec.

1.482-2(d)(2)(ii), Income Tax Regs. The best indication of such

arm's-length consideration generally is transfers by the same

transferor to unrelated parties for the same or similar intangible

property under the same or similar circumstances. Id. If a

sufficiently similar transaction involving an unrelated party is
- 34 -

8 Sec. 1.482-2(d), Income Tax Regs., was effectively

superseded by sec. 1.482-4T, Temporary Income Tax Regs., 58 Fed.

Reg. 5263, 5287 (Jan. 21, 1993), generally effective for taxable

years beginning after April 21, 1993.

Additionally, sec. 482 was amended, for tax years beginning

after Dec. 31, 1986, by the addition of the following sentence at

the end thereof: "In the case of any transfer (or license) of

intangible property (within the meaning of section 936(h)(3)(B)),

the income with respect to such transfer or license shall be

commensurate with the income attributable to the intangible." 

Tax Reform Act of 1986, Pub. L. 99-514, sec. 1231(e)(1), 100

Stat. 2085, 2562-2563. The effect of the amendment to sec. 482

is that we may consider the actual profits realized by the

transferee through its use of the intangible property. H. Rept.

99-426, 425 (1985), 1986-3 C.B. (Vol. 2) 425 ("The committee does

not intend, however, that the inquiry as to the appropriate

compensation for the intangible be limited to the question of

whether it was appropriate considering only the facts in

existence at the time of the transfer. The committee intends

that consideration also be given the actual profit experience

realized as a consequence of the transfer.")

The statutory amendment to sec. 482 is apparently in

conflict with sec. 1.482-2(d)(2)(iii)(g), Income Tax Regs., which

provides that only the prospective profits to be realized by the

transferee through its use of the property may be considered in

the determination of the amount of an arm's-length consideration

(i.e., without consideration of subsequent actual profits). See

Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 601 (1989)

("Unlike both respondent and petitioners' experts, we find little

relevance in B&L Ireland's actual results of operations during

1981 and 1982. Such information would not have been available in

1980 to a potential licensee negotiating a license agreement

which was entered on January 1, 1981."), affd. 933 F.2d 1084 (2d

(continued...)

unavailable, the arm's-length consideration is determined by

evaluating various facts and circumstances. Sec.

1.482-2(d)(2)(iii), Income Tax Regs.

The relevant factors identified in section 1.482-2(d)(2)(iii),

Income Tax Regs., for determining the amount of an arm's-length

consideration where an adequately similar transaction is absent

are:8
- 35 -

8(...continued)

Cir. 1991).

(a) The prevailing rates in the same industry or for

similar property,

(b) The offers of competing transferors or the bids of

competing transferees,

(c) The terms of the transfer, including limitations on

the geographic area covered and the exclusive or nonexclusive

character of any rights granted,

(d) The uniqueness of the property and the period for

which it is likely to remain unique,

(e) The degree and duration of protection afforded to the

property under the laws of the relevant countries,

(f) Value of services rendered by the transferor to the

transferee in connection with the transfer within the meaning

of paragraph (b)(8) of this section,

(g) Prospective profits to be realized or costs to be

saved by the transferee through its use or subsequent transfer

of the property,

(h) The capital investment and starting up expenses

required of the transferee,

(i) The next subdivision is (j),

(j) The availability of substitutes for the property

transferred,

(k) The arm's length rates and prices paid by unrelated

parties where the property is resold or sublicensed to such

parties,

(l) The costs incurred by the transferor in developing the

property, and

(m) Any other fact or circumstance which unrelated parties

would have been likely to consider in determining the amount of

an arm's length consideration for the property.

c. The Court’s Holding as to the Arm’s-Length Royalty 

 Rate

We must decide whether the record contains a sufficiently

similar transaction involving an unrelated party. Petitioners point

to the license agreement entered into between Powertex and InstaBulk in settlement of their litigation as a sufficiently similar

transaction involving an unrelated party. Respondent disagrees,
- 36 -

primarily because the license was granted in settlement of

litigation. We agree with respondent.

Although we agree that the Powertex/Insta-Bulk license

agreement covering the Amoco patents represents a transfer involving

"the same or similar intangible property," we do not believe that

the transfer occurred under "the same or similar circumstances" as

the transfer in issue in the instant case. We believe that the

cross-license agreements which Powertex and Insta-Bulk entered into

represent nothing more than the price at which those parties were

willing to discontinue their litigation and do not necessarily

establish an arm's-length royalty rate. License fees negotiated in

settlement of litigation may not be indicative of a true arm'slength royalty rate because of the incentive to avoid high

litigation costs. See Rude v. Westcott, 130 U.S. 152, 164 (1889);

Panduit Corp v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152, 1164

n.11 (6th Cir. 1978). Consequently, we find that the

Powertex/Insta-Bulk license agreement covering the Amoco liner was

not a "sufficiently similar transaction" as contemplated by section

1.482-2(d)(2)(ii), Income Tax Regs.

Having found that the record does not contain a sufficiently

similar transaction involving an unrelated party, we must attempt to

construct an arm's-length royalty. In doing so, we look to the

relevant factors identified by section 1.482-2(d)(2)(iii), Income

Tax Regs.
- 37 -

We are not completely satisfied with the methodology employed

or the results reached by either party. We conclude that petitioner

has shown that the royalty rate advanced by respondent is

unreasonably low and therefore is arbitrary, capricious, and

unreasonable. Seagate Tech., Inc. & Consol. Subs. v. Commissioner,

supra; Sundstrand Corp. v. Commissioner, supra. On the other hand,

we believe that the royalty rate advocated by petitioner is

unreasonably high for the property involved in this case. We have

evaluated all of the arguments raised by the parties. In reaching

our conclusion, we draw on the record as a whole to determine the

royalty rate at which we believe unrelated parties, under the facts

and circumstances of the instant case, would have arrived for the

intangibles in issue, see Sundstrand Corp. v. Commissioner, 96 T.C.

at 383; Bausch & Lomb, Inc. v. Commissioner, supra at 597, and we

concentrate only on those factors that we believe are necessary to a

complete understanding of our holding as to what would be a

reasonable arm's-length consideration for the license of the patent.

We have carefully scrutinized the experts' reports and the

clarifying testimony given at trial by each expert as to his

respective report. We are not constrained to follow the opinion of

any expert when the opinion is contrary to our own judgment. We may

adopt or reject expert testimony, whichever in our judgment is most

appropriate. Helvering v. National Grocery Co., 304 U.S. 282, 295

(1938); Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),

affg. T.C. Memo. 1974-285. We are not limited to choosing the
- 38 -

opinion of one expert over another, but may extract relevant

findings from each in reaching our own conclusions. Chiu v.

Commissioner, 84 T.C. 722, 734 (1985).

We find significant errors in the approach of each of the

parties' experts in determining a reasonable royalty rate. For

example, Mr. Parker proceeded under the assumption that a

prospective licensee would have no doubts as to the validity,

enforceability, and ownership of the Amoco patents. He made no

attempt to quantify the differences between the licenses of the Sea

Bulk patents and the license of the Amoco patents.

Mr. Thomas relied on the license of the Amoco patents by

Powertex to Insta-Bulk in settlement of their litigation as a

sufficiently similar transaction involving an unrelated party. As

we noted above, however, the fact that this license was granted in

settlement of litigation prevented it from being a sufficiently

similar transaction for purposes of section 1.482-2(d)(2)(ii),

Income Tax Regs. Additionally, we are puzzled as to his decision to

examine the factors found in Georgia-Pacific Corp. v. U.S. Plywood

Corp., 318 F. Supp. at 1120, instead of those enumerated in section

1.482-2(d)(2)(iii), Income Tax Regs. Although some of the GeorgiaPacific Corp. factors are similar to those listed in the regulation,

several are not. For example, the Georgia-Pacific Corp. factors

include the derivative effect of selling the patented product in

promoting sales of other products of the licensee and opinions from

expert witnesses, factors which are not included in the regulation. 
- 39 -

9 In a previous case before a Federal District Court in Texas,

Mr. Goldscheider offered expert testimony on the subject of what

a reasonable royalty would be and the judge in that case

commented that Mr. Goldscheider's credibility was adversely

affected due to his appearance as an advocate rather than a

detached expert. Kerwit Medical Prods., Inc. v. N & H

Instruments, Inc., 224 U.S.P.Q. 679, 691 n.6 (N.D. Tex. 1984). 

We will tolerate no less than detached neutrality from an expert

witness. See Estate of Halas v. Commissioner, 94 T.C. 570, 577-

579 (1990). An expert witness loses his usefulness and

credibility by becoming merely an advocate for one side. See,

e.g., Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74

T.C. 441, 452 (1980).

Finally, Mr. Thomas' basic approach was to rely on the

Powertex/Insta-Bulk settlement license of the Amoco patents as

evidence of a "clearly arm's-length transaction." He then pointed

to the advantages inherent in the Tri-Podd license agreement as

justifying a royalty of "greater than * * * 11% * * * probably 15%",

with no effort to quantify the effect of the asserted advantages.

As to Mr. Goldscheider, his entire opinion is grounded on Mr.

Lutzker's opinion that the Amoco patents are invalid, unenforceable,

and owned by Powertex. He made no attempt to evaluate the relevant

factors identified in section 1.482-2(d)(2)(iii), Income Tax Regs.,

and his reports added little to what was provided by Mr. Lutzker. 

Moreover, we found Mr. Goldscheider's demeanor at the trial to take

away from his credibility, as he acted more like an advocate, rather

than the independent and detached professional that he should have

been.9

Consequently, we will evaluate the appropriate factors set

forth in section 1.482-2(d)(2)(iii), Income Tax Regs., in order to
- 40 -

10 Because the license by Powertex of the Amoco patents to

Insta-Bulk was granted in settlement of litigation, we do not

consider it useful here.

11 Mr. Parker, petitioner's expert, ignored the provision in

the agreement requiring Powertex to also pay 10 percent of net

sales for the purpose of marketing, advertising, and promotion

when he evaluated the royalties payable by Powertex for use of

the Sea Bulk patents. We do likewise.

determine the arm's-length consideration for the property

transferred to Powertex.

In arriving at our conclusion, we begin by considering the

prevailing royalty rates for intermodal container liners as

established by the record. The only liner for which we have data

concerning licenses granted to unrelated third parties is the Sea

Bulk liner.10 The record reveals that the license agreements for

use of the Sea Bulk liner patents have provided many different

royalty rates. Sea-Land initially licensed the Sea Bulk patents to

Tri-Wall Containers in exchange for royalties of 8 percent of net

sales for the first year, 9 percent for the second year, and 10

percent for subsequent years. Sea-Land licensed the Sea Bulk

patents to Powertex initially for a 10-percent royalty, then

included quantity discounts which could reduce the royalty first to

7 1⁄2 percent and then to 5 percent, and finally for a flat 5 percent

for all sales after September 30, 1985.11 Powertex sublicensed the

Sea Bulk patents to Insta-Bulk in an agreement providing for 18-

percent royalties in the first year and 20 percent thereafter. The
- 41 -

agreement was later amended to provide for royalties at a 13-percent

rate, effective January 1, 1989.

Accordingly, by 1989, the Sea Bulk patents were being licensed

at royalty rates of 5 percent and 13 percent. We believe that this

range of royalties circumscribes the appropriate royalty rate to be

paid for use of the Amoco patents as well.

Petitioners describe the Amoco patents as being superior to the

Sea Bulk patents, and therefore capable of commanding higher royalty

rates. We believe, however, that the Amoco patents can best be

described as more specialized and designed for a particular use,

whereas the Sea Bulk patents were intended for more general usage.

Petitioners also point to the substantial increase in profits

of Powertex that resulted from sales of the Amoco liners as a factor

to justify a high royalty rate. Although we agree that the Amoco

patents were an important factor in generating those profits, we

believe that they were not the only catalyst. During 1987, Amoco

chose Powertex as its sole source of intermodal container liners, in

part because they had developed a good working relationship and

Powertex had agreed to build a facility near Amoco's Cooper River

plant. The skill and expertise which the Podds had accumulated in

designing and manufacturing liners also influenced the profitability

of Powertex. Consequently, we do not agree with petitioners that

the substantial increase in profits of Powertex is attributable

exclusively to use of the Amoco patents.
- 42 -

The expert witnesses who appeared in the instant case presented

us with an overwhelming amount of information and arguments

concerning the validity, enforceability, and ownership of the Amoco

patents. In our Order dated December 6, 1996, we stated that the

parties were not permitted to introduce evidence to collaterally

attack the validity of the patents in this Court, Adams v.

Commissioner, 23 B.T.A. 71, 103 (1931), affd. 65 F.2d 262 (5th Cir.

1933); R.M. Smith, Inc. v. Commissioner, T.C. Memo. 1977-23, but

that the parties were permitted to introduce such evidence to show

the scope of the patents, the potential availability of

noninfringing substitutes, the potential for litigation over the

validity of the patents, and how such matters might affect the

royalty rate that would be set by parties bargaining at arm's

length. After evaluating the evidence and the arguments presented

by the parties, we believe that a licensee of the Amoco patents

would consider these issues when negotiating a royalty rate for

their usage. See Smith v. Commissioner, T.C. Memo. 1981-219 ("a

potential purchaser of a patent will consider its validity,

difficulty of enforcement, and potential litigation as relevant to

the amount it is willing to pay."), affd. without published opinion

691 F.2d 508 (9th Cir. 1982).

We believe that an evaluation of the foregoing factors results

in a royalty towards the middle of the 5- to 13-percent range we

identified above. Using our best judgment, and evaluating the

record as a whole, we conclude that a royalty of 9 percent of net
- 43 -

12 Respondent also disallowed the royalty expense deductions

claimed by Powertex under sec. 162 on the grounds that they were

not ordinary and necessary business expenses, on the grounds that

Powertex actually owned, or at least had shop rights in, the

Amoco patents. In light of our holding that a royalty of 9

percent constitutes an arm's-length consideration pursuant to

sec. 482, such a royalty is deductible pursuant to sec. 162 as

well. See R.T. French Co. v. Commissioner, 60 T.C. 836, 849

(1973) (the arm's-length test commonly associated with sec. 482

is equally applicable in ascertaining the ordinary and necessary

character of a payment to a related party that is deducted under

sec. 162(a)).

sales of Amoco liners is a reasonable arm's-length consideration

pursuant to section 482 for the intangibles in issue.12

III. Issue 2: Whether Consulting Fees Paid by Powertex to

Special Commodities Services, Inc. Are Ordinary and Necessary

Business Expenses Deductible Under Section 162

FINDINGS OF FACT

From 1983 through 1992, James L. Clark (Mr. Clark) was employed

by Sea-Land as its Director of Corporate Terminal Operations and

Director of Special Commodities Services. His responsibilities

included managing the license agreement between Powertex and SeaLand, and providing technical support, marketing assistance, and

advice for assisting Sea-Land's customers in using Sea Bulk liners. 

Pursuant to the license agreement between Sea-Land and Powertex, Mr.

Clark was responsible for providing technical advice and marketing

assistance to Powertex during the first year of the agreement, and,

subsequently, for using his best efforts to assist Powertex in

promoting Sea Bulk liners.

As a Sea-Land employee, Mr. Clark negotiated and executed the

1983 license agreement between Powertex and Sea-Land, several
- 44 -

amendments to the agreement lowering the royalty rate, Sea-Land's

1989 agreement to sell the Sea Bulk patents to Powertex, and SeaLand's 1989 agreement to license its Sea Bulk trademark to Powertex. 

Mr. Clark also approved the sublicense agreement between Powertex

and Insta-Bulk. 

During 1983, Mr. Clark authorized Sea-Land to give free freight

to Powertex for the shipment of liners to Powertex customers. Mr.

Clark retired from Sea-Land on December 20, 1992. Subsequently, on

March 19, 1993, the free freight arrangement for shipment of

Powertex liners to customers was terminated by Sea-Land.

On July 11, 1983, Mr. Clark incorporated Special Commodities

Services, Inc. (SCS) under the laws of the State of New Jersey. Mr.

Clark was the president of SCS, and Mary J. Clark was its secretary

and treasurer. The outstanding stock of SCS was owned 60 percent by

Mr. Clark, 30 percent by Mary J. Clark, and 5 percent each by Dana

J. and Mark A. Clark. 

During or around November 1983, Powertex began making periodic

payments to SCS. At some point, Mr. Podd and Mr. Clark executed an

agreement "dated as of November 18, 1983" concerning these payments

which provided:

WHEREAS, SCS, Inc. was, in part, instrumental in

Powertex's obtaining that exclusive license [the Sea-Land

license] through consultations with Powertex during and

subsequent to the negotiations between Powertex and Sea

Land * * *

WHEREAS Powertex and SCS, Inc. believe it to be in

their mutual best interests for Powertex to continue to

receive marketing and technical advice on the manufacture,

marketing and sales of Sea Bulk units * * *
- 45 -

 * * * * * * *

Powertex hereby grants to SCS, Inc. for the full term

of Powertex's exclusive licensing agreement with Sea Land

Service on the SEA-BULK units and any extension thereof,

this Consulting Agreement to utilize SCS, Inc.'s,

technical expertise in the manufacturing, marketing and

sale of the SEA BULK units throughout the world. 

The agreement provided that notices to SCS should be sent to Mr.

Clark's condominium located at 580 Patten Avenue, Unit #39, Long

Branch, New Jersey 07740. Mr. Clark did not purchase the

condominium until April 6, 1984. 

Pursuant to the agreement, Powertex was required to pay SCS a

"commission" of 2 1⁄2 percent of net sales of Sea Bulk liners by

Powertex and its sublicensee, Insta-Bulk. Beginning with the

quarter ending September 30, 1987, through February 25, 1992, the

"commission" was increased to 3 1⁄2 percent of net sales of Sea Bulk

liners, and, for sales by Insta-Bulk, the commission remained at 2 1⁄2

percent. During the period from mid-1985 through February 25, 1992,

Powertex paid approximately $927,451 to SCS pursuant to the

agreement. 

On October 26, 1995, Sea-Land filed a lawsuit in the Superior

Court of New Jersey against Mr. Clark, Mary J. Clark, SCS, Powertex,

and Mr. Podd, based on claims of fraud, commercial bribery,

conspiracy, and breach of fiduciary duties in order to recover the

payments made to SCS. The suit sought damages and demanded that SCS

return the payments made by Powertex. The relevant portions of the

complaint stated:
- 46 -

17. Unbeknownst to Sea-Land, in or about the time the 

Patent Licensing Agreement was negotiated and entered into 

between Powertex and Sea-Land, James Clark and Podd negotiated 

an additional compensation arrangement. In exchange for James 

Clark's insuring the "success" of the Patent Licensing 

Agreement, Podd agreed to pay James Clark a bribe or kickback 

equal to 2 1⁄2% of the sales of Sea-Bulk liners by Powertex. 

Upon information and belief, the kickbacks to James Clark were 

increased to 3 1⁄2% of sales in or about mid 1987.

18. In an effort to conceal the kickbacks paid to James 

Clark, Podd and Clark entered into a "consulting agreement" 

between Special Commodities Services, Inc. ("SCS") and 

Powertex. The consulting agreement was dated November 18, 1983

and executed by James Clark as the President of SCS, Mary Clark

as the Vice President, Secretary and Treasurer of SCS, and 

Victor Podd as President of Powertex.

19. Upon information and belief, SCS was a shell 

corporation established by James Clark for the sole purpose of 

concealing the kickbacks paid by Victor Podd and Powertex to 

James Clark. Upon information and belief, James Clark provided

no consulting services, or services of any kind, to Powertex or

Victor Podd. All of James Clark's activities regarding 

Powertex were in his role as an employee of Sea-Land. 

The lawsuit was settled in or around December 1996, with respect to

Mr. Clark, Mary Clark, and SCS, and during or around January 1997,

with respect to Powertex and Mr. Podd. The terms of the settlements

were not submitted in evidence.

OPINION

In the notice of deficiency, respondent disallowed the $219,289

deduction claimed by Powertex for "consulting fees" paid to SCS for

the fiscal year ending May 31, 1990. Respondent determined that the

fees were neither ordinary and necessary business expenses nor

expended for the designated purpose. Respondent did not assert that

the deduction for payments to SCS should be disallowed under section

162(c) as an illegal bribe or kickback. We suspect that

respondent's hesitancy to pursue a section 162(c)(2) argument is due
- 47 -

to the fact that respondent would bear the burden of proving, by

clear and convincing evidence, that the payments were illegal and

that the other requirements for disallowance under section 162(c)(2)

are satisfied. Brizell v. Commissioner, 93 T.C. 151, 161 (1989);

sec. 1.162-18(b)(4), Income Tax Regs. In any event, in the instant

case, we need not examine the legality of the payments to SCS.

Deductions are a matter of legislative grace, and a taxpayer

seeking a deduction must meet every condition that Congress has

imposed for entitlement to the deduction claimed. New Colonial Ice

Co. v. Helvering, 292 U.S. 435, 440 (1934). To qualify as an

allowable deduction under section 162(a) an item must (1) be paid or

incurred during the taxable year; (2) be for carrying on any trade

or business; (3) be an expense; (4) be a necessary expense; and (5)

be an ordinary expense. Commissioner v. Lincoln Sav. & Loan

Association, 403 U.S. 345, 352 (1971). Whether an expenditure is

ordinary and necessary is a question of fact to be decided on the

basis of all of the facts and circumstances. Commissioner v.

Heininger, 320 U.S. 467, 475 (1943); Hearn v. Commissioner, 309 F.2d

431, 431 (9th Cir. 1962), affg. 36 T.C. 672 (1961); Brizell v.

Commissioner, supra at 156.

In general, an expense is ordinary if it is considered "normal,

usual, or customary" in the context of the particular business out

of which it arose. Deputy v. Du Pont, 308 U.S. 488, 495-496 (1940). 

An expense is necessary if it is "appropriate and helpful" to the
- 48 -

operation of the taxpayer's trade or business. Welch v. Helvering,

290 U.S. 111, 113 (1933).

The test of deductibility of payments made for services is

whether the payments are reasonable and are in fact payments purely

for services which are actually rendered. Achiro v. Commissioner,

77 T.C. 881, 903 (1981); sec. 1.162-7(a), Income Tax Regs. What

matters is the nature of the services performed, and not the label

put on them by the payor and the payee. Estate of Boyd v.

Commissioner, 76 T.C. 646, 658 (1981) (and cases cited therein). 

Petitioners bear the burden of proving what portion of the fees is

allocable to deductible expenses. Id.

Petitioners contend that SCS "rendered continuous, substantial,

and valuable consulting services to Powertex" and consulted with

Powertex on "marketing, advertising, business planning, customer

development, new products, finance, etc." Petitioners, however,

submitted no records in evidence reflecting services performed by

SCS. Mr. Podd testified that he would call Mr. Clark at all hours

of the day and night seeking "direction, leadership, [and] knowledge

of the industry".

Neither party called Mr. Clark to testify at trial. Respondent

contends that petitioners' failure to call Mr. Clark allows us to

conclude that his testimony would not have supported their

arguments.

If a witness is equally available to both parties and neither

party calls that witness at trial, then no adverse inference is
- 49 -

warranted. Kean v. Commissioner, 469 F.2d 1183, 1187-1188 (9th Cir.

1972), affg. on this issue and revg. on another issue 51 T.C. 337,

343-344 (1968). It appears that Mr. Clark could have been

subpoenaed by either petitioners or respondent. Accordingly, we

draw no inference from the fact that neither party subpoenaed Mr.

Clark.

Nonetheless, several aspects of the relationship between

Powertex, SCS, and Mr. Clark cause us to scrutinize the

relationships between them. During 1983, Mr. Clark negotiated and

executed the license agreement between Powertex and Sea-Land. 

During 1983, he also authorized Sea-Land to give free freight to

Powertex for shipment of its liners. Mr. Clark also incorporated

SCS in 1983 and entered into the "consulting agreement" between SCS

and Powertex. The "consulting agreement" provides that SCS will

provide "technical expertise in the manufacturing, marketing and

sale of the Sea Bulk units". Mr. Podd, however, admitted that Mr.

Clark had no experience in the liner industry and that his expertise

was in the refrigerated container industry. 

Mr. Clark left Sea-Land during 1992, and, within 3 months, the

free freight arrangement for shipment of Powertex liners was

terminated by Sea-Land. The Sea-Land lawsuit filed in 1995

describes the payments required by the "consulting agreement" as

bribes or kickbacks and contends that all of Mr. Clark's activities

with regard to Powertex were undertaken in his capacity as an

employee of Sea-Land. A deduction for a kickback has been allowed
- 50 -

when the payments were not shown by the Commissioner to be illegal

and the taxpayer established that the payments were ordinary and

necessary business expenses. See Brizell v. Commissioner, supra. 

In the instant case, however, petitioners consistently characterize

the payments to SCS as consulting fees, and they do not contend that

the payments are deductible as legal kickbacks. Moreover, even had

they made such a contention, they have failed to produce any

evidence which would suggest that kickbacks are normal and customary

in the container liner industry. See id. at 157 (kickbacks found to

be ordinary within the meaning of section 162(a) where the record

contained ample evidence that such payments were common in the

printing industry); Frederick Steel Co. v. Commissioner, 42 T.C. 13

(1964), revd. on other grounds 375 F.2d 351 (6th Cir. 1967)

(commercial bribes not ordinary because there was no reliable

evidence that other similar arrangements or practices were common in

the industry); United Draperies, Inc. v. Commissioner, 41 T.C. 457

(1964), affd. 340 F.2d 936 (7th Cir. 1964) (taxpayer failed to show

that it normally made such payments or that such payments were

commonly made in the industry).

Based on the record before us, we conclude that petitioners

have not established that Mr. Clark (individually or through SCS)

provided any services to Powertex beyond those he provided in his

capacity as an employee of Sea-Land. Consequently, we hold that
- 51 -

13 As we noted, the witness who could have offered the most

illuminating testimony concerning the services provided by SCS,

Mr. Clark, was not called to testify by either respondent or

petitioners. Given the fact that Mr. Clark authorized Sea-Land

to give free freight to Powertex for the shipment of liners to

Powertex customers, the free freight arrangement was terminated

shortly after Mr. Clark retired from Sea-Land, and thereafter

Sea-Land filed suit to recover the payments from Powertex to SCS,

the most plausible explanation for the payments is that they were

kickbacks to Mr. Clark. Petitioners have obvious reasons for not

contending that the payments were kickbacks, and respondent, as

noted, may have been reluctant to characterize the payments as

illegal kickbacks due to the burden of proof provision in sec.

162(c)(2). In any event, we are left with a less than adequate

record concerning the SCS payments, and it is petitioners' burden

to prove that such payments were ordinary and necessary business

expenses.

Powertex may not deduct the payments to SCS in 1990 in the amount of

$219,289 as an ordinary and necessary business expense.13

IV. Issue 3: Whether Amounts Deducted by Powertex as Management

Fees Paid to Powertex Plus International, Inc. Are Reasonable 

Payments for Services Rendered

FINDINGS OF FACT

During the years 1977 through 1990, the Podds and Mrs. Podd

were Canadian citizens. From 1977 through 1983, the Podds and Mrs.

Podd did not hold any immigration status or visa with the United

States. During 1977, the Immigration and Naturalization Service

(INS) detained Mr. Podd while he was crossing the United

States/Canadian border and questioned him about his immigration

status and right to work in the United States. 

On September 19, 1977, Powertex Plus International, Inc. (Plus)

was incorporated in Canada by Mr. Podd, originally under the name

Powerweb Corporation, Ltd. Petitioners' law firm advised Mr. Podd
- 52 -

to incorporate and receive wages from Plus in Canada because of the

prohibition against a Canadian citizen's working in the United

States without a visa. 

During the years 1983 through 1990, Mr. Podd owned 28 percent

of the outstanding stock of Plus, and Mrs. Podd, Stephen, and

Victor, Jr. each owned 24 percent. Mr. Podd was its president, Mrs.

Podd was its secretary, and Stephen and Victor, Jr. were vice

presidents. The Podds and Mrs. Podd were also the only employees of

Plus during this time period. 

A "Management Agreement" dated June 1, 1983, and executed by

Victor, Jr. as vice president of Powertex, and Mr. Podd as president

of Plus provided that Plus would "operate" Powertex for the period

from June 1, 1983, to May 30, 1984, in return for "compensation" of

$120,000. The agreement provided that it could be terminated by

mutual agreement and otherwise would be automatically renewed for

successive 3 year terms. Mr. Podd and Victor, Jr. prepared three

amendments to the management agreement increasing the "compensation"

payable to Plus to $125,000 for fiscal year 1985, $175,000 for

fiscal year 1987, and $250,000 for fiscal years 1988 through 1990. 

Although the amendments stated that they were executed on May 10,

1984, May 22, 1986, and May 11, 1987, they were not actually

executed until late 1990 or early 1991. 

Powertex made payments to Plus as follows:
- 53 -

Date Amount

Aug. 31, 1987 $50,000

Oct. 22, 1987 75,000

Mar. 10, 1988 75,000

May 25, 1988 50,000

Jan. 17, 1989 125,000

May 26, 1989 125,000

Mar. 2, 1990 125,000

May 23, 1990 125,000

 During the fiscal years ending May 31, 1984, through May 31, 1990,

Powertex claimed deductions on its Federal corporate income tax

returns for payments to Plus in the following amounts:

Fiscal Year

Ending Amount

May 31, 1984 $120,000

May 31, 1985 125,000

May 31, 1986 125,000

May 31, 1987 175,000

May 31, 1988 250,000

May 31, 1989 250,000

May 31, 1990 250,000 

During the years 1983 through 1990, Plus' place of business was

located at 255 Beverley Avenue, Montreal, Quebec, Canada, which was

also used as a residence by Mr. Podd, Mrs. Podd, and Stephen during

such years. Additionally, Powertex deducted expenses for an office

maintained at the 255 Beverly Avenue address on its Federal

corporate income tax returns for the fiscal years ending May 31,

1984, through May 31, 1990. During the same period, however,

Powertex also maintained offices at the Rouses Point facility for

use by the Podds and Mrs. Podd. 
- 54 -

During the fiscal years ending May 31, 1989 and 1990, Powertex

claimed depreciation deductions on its Federal corporate income tax

returns for a desk, chair, and other standard office furniture

located at 255 Beverly Avenue. Powertex also paid the Podds'

worldwide travel and entertainment expenses. Plus paid the

following wages in Canadian dollars:

Year Mr. Podd Mrs. Podd Victor, Jr. Stephen

1988 $70,000 $60,000 $35,000 $35,000

1989 61,525 61,525 49,215 49,215

1990 100,000 100,000 25,000 25,000 

OPINION

In the notices of deficiency, respondent adjusted the income of

Powertex by disallowing the deductions claimed for management fees

paid to Plus for the fiscal years ending in 1988 through 1990. 

Respondent determined that such amounts were neither ordinary and

necessary business expenses nor expended for the purpose designated.

Deductions are a matter of legislative grace, and a taxpayer

seeking a deduction must meet every condition that Congress has

imposed for entitlement to the deduction claimed. New Colonial Ice

Co. v. Helvering, 292 U.S. at 440. Section 162 generally allows a

deduction for ordinary and necessary expenses paid or incurred

during the taxable year in carrying on a trade or business. The

determination of whether an expenditure satisfies the requirements

of deductibility under section 162 is a question of fact to be
- 55 -

decided on the basis of all of the facts and circumstances. 

Commissioner v. Heininger, 320 U.S. at 475; Hearn v. Commissioner,

309 F.2d at 431; Brizell v. Commissioner, 93 T.C. at 156.

In general, an expense is ordinary if it is considered "normal,

usual, or customary" in the context of the particular business out

of which it arose. Deputy v. Du Pont, 308 U.S. at 495-496. An

expense is necessary if it is "appropriate and helpful" to the

operation of the taxpayer's trade or business. Welch v. Helvering,

290 U.S. at 113.

Management expenses are among the items included in business

expenses. Sec. 1.162-1, Income Tax Regs. The test of deductibility

of payments made for services is whether the payments are reasonable

and are in fact payments purely for services which are actually

rendered. Achiro v. Commissioner, 77 T.C. at 903; sec. 1.162-7(a),

Income Tax Regs. What matters is the nature of the services

performed, and not the label put on them by the payor and the payee. 

Estate of Boyd v. Commissioner, 76 T.C. at 658 (and cases cited

therein). Petitioners bear the burden of proving what portion of

the fees is allocable to deductible expenses. Id.

Petitioners argue that the amounts labeled as management fees

paid from Powertex to Plus are deductible under section 162 as

ordinary and necessary business expenses. Petitioners contend that

Plus provided substantial, regular, and valuable management
- 56 -

14 On brief, respondent concedes that Mr. Podd did not receive

dividend income of $2,749,501 from his constructive receipt of

the Amoco patents from Powertex via the granting of patent rights

in his name during 1989. Petitioners conceded some of the items

of dividend income in the stipulations of facts. The only items

(continued...)

services. Mr. Podd testified that Plus provided Powertex services

in the nature of "general guidance" and "direction". More

specifically, it was Mr. Podd's uncontroverted testimony that Plus

reviewed sales invoices and entertained customers of Powertex.

Respondent contends that the fees paid to Plus are not

deductible because they lacked a business purpose and because Plus

was merely a holding company which failed to provide any significant

services to Powertex.

Respondent does not argue that the management fee payments were

not reasonable. At trial, petitioners offered credible testimony

that significant services were provided to Powertex through Plus. 

On the record before us, we hold that the payments made by Powertex

to Plus as management fees during the years in issue were for

services actually rendered and that, therefore, they are deductible

under section 162.

IV. Issue 4: Whether Individual Petitioners Received

Constructive Dividends

FINDINGS OF FACT

Respondent determined that the Podds and Mrs. Podd received

constructive dividends from a variety of sources.14
- 57 -

14(...continued)

of dividend income petitioners address on brief concern the

constructive dividends that respondent determined were

attributable to the disallowed management fees paid by Powertex

to Plus and the disallowed royalty expenses. Accordingly, we

consider the individual petitioners to have conceded that they

received constructive dividends as determined by respondent,

except as to those amounts related to the disallowed royalty and

management fee expenses and the granting of patent rights to Mr.

Podd during 1989. See Rybak v. Commissioner, 91 T.C. 524, 566

n.19 (1988).

Respondent determined that Mr. Podd, Victor, Jr., and Stephen

each received constructive dividend income of $228,678 during 1989

and $177,027 during 1990, which amounts are 1/3 of the disallowed

royalty expenses claimed by Powertex of $686,034 during 1989 and

$531,082 during 1990. Additionally, in accordance with respondent's

determination that the $250,000 management fee expenses paid by

Powertex to Plus for the 1988 through 1990 taxable years were not

ordinary and necessary business expenses, respondent determined that

such payments constituted constructive dividends. Initially,

respondent determined in the notices of deficiency that Mr. Podd

received $250,000 of constructive dividend income for 1988 and 1989,

and that the Podds and Mrs. Podd received $250,000 of constructive

dividend income for 1990. By way of amended answers, respondent

also determined that Victor, Jr. and Stephen each received $250,000

of constructive dividend income for 1988 and 1989.
- 58 -

OPINION

A dividend is a distribution of property by a corporation to

its shareholders out of its earnings and profits. Sec. 316(a). 

Dividends are taxable as ordinary income to shareholders to the

extent of the earnings and profits of the corporation. Sec. 316. A

dividend need not be formally declared or even intended by the

corporation. Noble v. Commissioner, 368 F.2d 439, 442 (9th Cir.

1966), affg. T.C. Memo. 1965-84; Commissioner v. Makransky, 321 F.2d

598 (3d Cir. 1963), affg. 36 T.C. 446 (1961); Sachs v. Commissioner,

277 F.2d 879 (8th Cir. 1960), affg. 32 T.C. 815 (1959). 

Additionally, the distribution need not be made to a shareholder,

but only for the shareholder's personal benefit. Cirelli v.

Commissioner, 82 T.C. 335, 351 (1984); Edgar v. Commissioner, 56

T.C. 717 (1971). The determination of whether a constructive

dividend has occurred is a question of fact which depends on each

case. Hardin v. United States, 461 F.2d 865 (5th Cir. 1972).

The only argument petitioners advance with respect to the

royalty payments is that the full amount of such payments is

deductible as an ordinary and necessary business expense and

therefore cannot be a constructive dividend. As discussed supra, we

have found that the appropriate royalty rate for the patents

licensed pursuant to the Tri-Podd license agreement is 9 percent. 

To the extent that royalty payments were made in excess of 9
- 59 -

percent, such amounts are not ordinary and necessary business

expenses. Consequently, the excess is nondeductible expenditures

made by Powertex for the personal benefit of its shareholders and

constitute constructive dividends to the Podds. See Meridian Wood

Prods. Co., Inc. v. United States, 725 F.2d 1183, 1191 (9th Cir.

1984); Falsetti v. Commissioner, 85 T.C. 332, 356-358 (1985);

Challenge Manufacturing Co. v. Commissioner, 37 T.C. 650, 663

(1962).

With regard to the $250,000 management fee expenses paid by

Powertex to Plus for the 1988 through 1990 taxable years, we held

above that such payments were ordinary and necessary business

expenses pursuant to section 162, and, accordingly, we hold that

these payments are not constructive dividends.

VI. Issue 5: Whether Victor, Jr. Was a Resident of the United

States During 1990

FINDINGS OF FACT

Victor, Jr. is a Canadian citizen. Beginning in 1970, the Podd

family resided at their home at 255 Beverly Avenue, Mount Royal,

Montreal, Canada. During 1984, Victor, Jr. was granted an H-3 Visa

by the United States. On July 6, 1987, Victor, Jr. filed an

application for resident alien immigration status with the

Immigration and Naturalization Service (INS). On July 7, 1987,

Victor, Jr. obtained a United States resident alien green card from

the INS entitling him to resident alien status. From July 7, 1987,
- 60 -

through December 31, 1990, Victor, Jr. held resident alien

immigration status with the United States. 

During January 1989, Victor, Jr. met Ann Cohen, a resident of

6217-2 Bay Club Drive, Fort Lauderdale, Florida. Victor, Jr. and

Ms. Cohen eventually began dating and were married on August 16,

1991. 

During 1990, Victor, Jr. conducted business for Powertex in

Florida by contacting and meeting with its Florida customers.

Victor, Jr. utilized a phone, desk, and fax machine located in Ms.

Cohen's apartment for conducting Powertex business. Victor, Jr.

also utilized an automobile owned by Powertex while in Florida

during 1990. On March 26, 1990, Powertex purchased mobile telephone

service for Victor, Jr.'s use at Ms. Cohen's apartment. During or

around May of 1990, Victor, Jr. transported a boat that he owned

with Stephen from Rouses Point, New York to Fort Lauderdale,

Florida, docking it at the marina servicing Ms. Cohen's apartment. 

In the insurance policy covering the boat, Victor, Jr. listed Ms.

Cohen's apartment as his address and the address where the boat is

normally kept. 

On August 22, 1990, Victor, Jr. obtained a driver's license

issued by the State of Florida. Again, Ms. Cohen's apartment is

listed as his address. During 1990, Victor, Jr. incurred charges on
- 61 -

his credit card for 160 days in Florida and for 55 days in other

locations in the United States. 

For the 1990 taxable year, Victor, Jr. filed a Canadian

resident income tax return. For the 1991 taxable year, Victor, Jr.

claimed that he was a United States resident for income tax purposes

and resided in Fort Lauderdale, Florida. 

During 1990, Victor, Jr. also held a Quebec driver's license

and belonged to a health club in Montreal. He owned two automobiles

which were registered in Montreal and garaged at his parents' home. 

Many of his personal belongings remained in his parents' home. He

maintained bank accounts at four Montreal banks in 1990. During

1990, he also received personal services from a doctor, a dentist, a

hairdresser, and a tailor in Montreal. 

OPINION

For purposes of the Federal income tax, an alien individual

will be treated as a resident alien of the United States with

respect to any calendar year if, at any time during such calendar

year, the individual is a lawful permanent resident of the United

States. Sec. 7701(b)(1)(A)(i); sec. 301.7701(b)-1(b)(1), Proced. &

Admin. Regs. An individual is a lawful permanent resident of the

United States at any time if (1) the individual has the status of

having been lawfully accorded the privilege of permanently residing
- 62 -

15 United States income tax treaties are on equal footing with

domestic law in that both are "the supreme Law of the Land". 

U.S. Const. art. VI, cl. 2; see also sec. 894(a) ("The provisions

of this title shall be applied to any taxpayer with due regard to

(continued...)

in the United States as an immigrant in accordance with the

immigration laws (i.e., such individual holds a "green card"), and

(2) that status has not been revoked (and has not been

administratively or judicially determined to have been abandoned). 

Sec. 7701(b)(6); sec. 301.7701(b)-1(b)(1), Proced. & Admin. Regs. 

An alien individual who is issued a "green card" is considered a

resident alien of the United States for United States income tax

purposes on the first day that the individual is present in the

United States as a lawful permanent resident, regardless of the

number of days that the individual is present in the United States. 

Sec. 7701(b)(2)(A)(ii); sec. 301.7701(b)-4(a), Proced. & Admin.

Regs.

Accordingly, because Victor, Jr. held a valid green card during

1990, he generally would be treated as a resident alien of the

United States with respect to that year. If, for income tax

purposes, Canada also considered Victor, Jr. to be a resident of

that country for 1990, he potentially would be subject to double

taxation. The United States-Canada income tax treaty (the treaty),

however, provides a method for alleviating such potential.15 The
- 63 -

15(...continued)

any treaty obligation of the United States which applies to such

taxpayer."); sec. 7852(d)(1) ("For purposes of determining the

relationship between a provision of a treaty and any law of the

United States affecting revenue, neither the treaty nor the law

shall have preferential status by reason of its being a treaty or

law.")

If a treaty conflicts with a Federal law, the later in time

will prevail. Chae Chan Ping v. United States, 130 U.S. 581, 600

(1889); Whitney v. Robertson, 124 U.S. 190, 194 (1888); see also

Lindsey v. Commissioner, 98 T.C. 672, 676 (1992), affd. without

published opinion 15 F.3d 1160 (D.C. Cir. 1994).

treaty provides a series of so-called "tie-breaker" rules for

determining residence where an individual qualifies as a resident of

both countries, as follows:

2. Where by reason of the provisions of paragraph 1 an 

individual is a resident of both Contracting States, then his 

status shall be determined as follows:

 (a) He shall be deemed to be a resident of the 

Contracting State in which he has a permanent home 

available to him; if he has a permanent home available to 

him in both States or in neither State, he shall be deemed 

to be a resident of the Contracting State with which his 

personal and economic relations are closer (centre of 

vital interests);

 (b) If the Contracting State in which he has his 

centre of vital interests cannot be determined, he shall 

be deemed to be a resident of the Contracting State in 

which he has an habitual abode;

 (c) If he has an habitual abode in both States or in 

neither State, he shall be deemed to be a resident of the 

Contracting State of which he is a citizen; and

 (d) If he is a citizen of both States or of neither of

them, the competent authorities of the Contracting States 

shall settle the question by mutual agreement. 
- 64 -

16 On Aug. 31, 1994, the United States and Canada signed a

third protocol to the treaty. A revised protocol was signed by

the United States and Canada on Mar. 17, 1995, and replaced the

protocol signed during Aug. 1994. The revised protocol modified

the definition of resident contained in article IV. The new

definition, however, is not applicable to the year at issue.

A fourth protocol between the United States and Canada was

signed in Ottawa during July 1997. On June 8, 1998, the IRS

announced that the United States recently exchanged instruments

of ratification for this protocol with Canada. Announcement 98-

47, 1998-23 I.R.B. 5 (June 8, 1998).

[Convention Between the United States of America and Canada with

Respect to Taxes on Income and on Capital, Sept. 26, 1980, art. IV,

par. 2, T.I.A.S. No. 11,087, 1986-2 C.B. 258, 259, as amended by

protocol, June 14, 1983, 1986-2 C.B. 270, and by second protocol,

Mar. 28, 1984, 1986-2 C.B. 274 (hereinafter, Canada Convention).]

Paragraph 1 of the treaty defines the term "resident" as

follows:

1. For the purposes of this Convention, the term "resident of

a Contracting State" means any person who, under the laws of that

State, is liable to tax therein by reason of his domicile,

residence, place of management, place of incorporation or any other

criterion of a similar nature, but in the case of an estate or

trust, only to the extent that income derived by such estate or

trust is liable to tax in that State, either in its hands or in the

hands of its beneficiaries. [Canada Convention, art. IV, par. 1.]16

Consequently, for the "tie-breaker" rules to apply, it must be

shown that, in addition to being a resident of the United States,

Victor, Jr. also is treated as a Canadian resident under Canadian

law for the 1990 taxable year. Victor, Jr. has introduced evidence

tending to show his physical, social, and personal nexus with

Canada. Neither party, however, has introduced any evidence of the
- 65 -

Canadian law concerning residence. In the absence of any evidence

regarding the Canadian law for determining residence for income tax

purposes, we conclude that Victor, Jr. was not a Canadian resident

for income tax purposes in 1990. See MacLean v. Commissioner, 73

T.C. 1045, 1053 (1980) (petitioner not considered a resident of the

United Kingdom where he failed to cite any United Kingdom statutory

or case law authority); Afshar v. Commissioner, T.C. Memo. 1981-241

("where neither party has offered any material with respect to the

applicable foreign law, we need not take judicial notice of such

law"), affd. without published opinion 692 F.2d 751 (4th Cir. 1982). 

Accordingly, the "tie-breaker" rules of the treaty are inapplicable. 

Consequently, we hold that Victor, Jr. is a resident of the United

States for 1990 pursuant to section 7701(b)(1)(A)(i).

VII. Issue 6: Additions to Tax and Penalties

FINDINGS OF FACT

Respondent determined additions to tax for negligence under

section 6653(a)(1)(A) and (B), additions to tax for negligence under

section 6653(a)(1), additions to tax for substantial understatements

under section 6661(a), and accuracy-related penalties for negligence

or substantial understatements under section 6662(a). Respondent

also determined additions to tax for failure to file tax returns
- 66 -

under section 6651(a)(1) and additions to tax for failure to make

deposit of taxes under section 6656.

OPINION

1. Underpayment Due to Negligence

Section 6653(a)(1)(A) (and section 6653(a)(1)) imposes an

addition to tax equal to 5 percent of the underpayment of tax if any

part of the underpayment is due to negligence or intentional

disregard of rules or regulations. Section 6653(a)(1)(B) provides

for an addition of 50 percent of the interest payable under section

6601 on the portion of the underpayment attributable to negligence

or intentional disregard of rules or regulations. Section 6662(a)

and (b)(1) imposes a penalty equal to 20 percent of the portion of

the underpayment that is attributable to negligence or disregard of

rules or regulations. Negligence includes a failure to make a

reasonable attempt to comply with the provisions of the Internal

Revenue laws or to exercise ordinary and reasonable care in the

preparation of a tax return. Sec. 6662(c). Negligence is a lack of

due care or failure to do what a reasonable and ordinarily prudent

person would do under the circumstances. Zmuda v. Commissioner, 731

F.2d 1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982); Neely v.

Commissioner, 85 T.C. 934 (1985). The term "disregard" includes any

careless, reckless, or intentional disregard. Secs. 6653(a)(3),
- 67 -

6662(c); sec. 1.6662-3(b)(2), Income Tax Regs. The section 6662

accuracy-related penalty does not apply with respect to any portion

of an underpayment if reasonable cause exists for the underpayment

and the taxpayer acted in good faith with respect to such portion. 

Sec. 6664(c)(1). The determination of whether the taxpayer acted

with reasonable cause and in good faith depends upon the pertinent

facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.

2. Substantial Understatement

Section 6661 imposes an addition to tax in an amount equal to

25 percent of the underpayment of income tax if the underpayment is

attributable to a substantial understatement. Section 6661 applies

to tax returns with a due date prior to January 1, 1990. Section

6661 was repealed with regard to returns having a due date after

December 31, 1989, and recodified in section 6662. Section 6662(a)

and (b)(2) imposes a penalty in an amount equal to 20 percent of the

portion of underpayment which is attributable to any substantial

understatement of income tax.

For purposes of sections 6661 and 6662(a), an understatement is

substantial if it exceeds the greater of 10 percent of the correct

tax or $5,000 or, in the case of a corporate taxpayer, $10,000. 

Secs. 6661(b)(1)(A) and (B), 6662(d)(1)(A) and (B). The term

"understatement" is defined as the excess of the amount of tax
- 68 -

required to be shown on the return for the taxable year over the

amount of tax shown on the return for the taxable year reduced by

any rebate. Secs. 6661(b)(2), 6662(d)(2)(A). In calculating

understatements, items for which there was substantial authority or

adequate disclosure are not to be considered. Secs.

6661(b)(2)(B)(i) and (ii), 6662(d)(2)(B)(i) and (ii).

3. Failure To File Tax Return

Section 6651(a)(1) provides for an addition to tax of 5 percent

of the tax required to be shown on the return for each month or

fraction thereof for which there is a failure to file, not to exceed

25 percent. The addition to tax for failure to file a return timely

will be imposed if a return is not timely filed unless the taxpayer

shows that the delay was due to reasonable cause and not willful

neglect. Sec. 6651(a)(1).

4. Failure To Make Deposit of Taxes

Section 6656(a) imposes an addition to tax for failure to

deposit timely a tax in a Government depositary, unless it is shown

that such failure was due to reasonable cause and not due to willful

neglect. For additions to tax assessed after October 21, 1986, the

amount of the addition is 10 percent of the underpayment. Sec.

6656(a). For deposits required to be made after December 31, 1989,
- 69 -

the addition is 10 percent of the underpayment in cases where the

delinquency persists for more than 15 days.

Petitioners argue that they are not liable for any of the

penalties and additions to tax because they reasonably relied on the

advice of competent tax experts.

If a taxpayer reasonably relies in good faith upon the advice

of a competent tax professional in the preparation of the taxpayer's

return, the penalties and additions to tax such as those in issue in

the instant case may be inapplicable. See United States v. Boyle,

469 U.S. 241, 250-251 (1985) (failure to file); Vorsheck v.

Commissioner, 933 F.2d 757, 759 (9th Cir. 1991) (substantial

understatement); Weis v. Commissioner, 94 T.C. 473, 487 (1990)

(negligence); Housden v. Commissioner, T.C. Memo. 1992-91 (failure

to make deposit of taxes).

The individual petitioners were Canadian citizens unfamiliar

with the U.S. tax system. They sought assistance from a certified

public accountant in the United States in order to comply with the

provisions of the Internal Revenue Code. The accountant for the

individual petitioners and Powertex, Ronald R. Plante, a C.P.A. with

Peat Marwick, testified as to his role in the preparation of

petitioners' tax returns. Mr. Plante had a longstanding

professional association with Powertex and the individual
- 70 -

petitioners, which began around 1977 or 1978. Mr. Plante credibly

testified that petitioners sought his advice in order to fulfill

their tax obligations in the United States. It is well documented

in the record that petitioners relied upon the advice of Mr. Plante.

It is obvious that Mr. Plante possessed sufficient expertise in

the field of tax law, and we believe that, with the exception of the

issue concerning the deduction claimed by Powertex for consulting

fees paid to SCS, petitioners provided him with the necessary and

relevant information to prepare their tax returns. After a careful

review of the record, we hold that, based on all the facts and

circumstances, except as to the SCS consulting fees issue,

petitioners reasonably relied in good faith on the advice of Mr.

Plante and are therefore not liable for the penalties and additions

to tax as determined by respondent.

As to the SCS consulting fees issue, we hold that petitioners

have not met the requirements of the reasonable cause exception that

are necessary to avoid imposition of the section 6662(a) accuracyrelated penalty. If a taxpayer relies reasonably and in good faith

upon the advice of a competent and experienced accountant in the

preparation of the taxpayer's return, the penalty for negligence or

the intentional disregard of rules or regulations is not applicable. 

Weis v. Commissioner, supra at 487. To show good faith reliance,
- 71 -

the taxpayer must show that the return preparer was supplied with

all the necessary information and the incorrect return was a result

of the preparer's mistakes. Pessin v. Commissioner, 59 T.C. 473,

489 (1972); sec. 1.6664-4(c)(1)(i), Income Tax Regs.

Although petitioners' C.P.A., Ronald Plante, testified at

trial, he did not state whether he was provided any information with

respect to the SCS consulting fees issue. Under the circumstances,

we hold that Powertex has failed to establish that it furnished Mr.

Plante with necessary and relevant information with regard to the

consulting fees paid to SCS and that the incorrect treatment of this

issue was due to his mistakes. Accordingly, we hold that Powertex

is liable for the section 6662(a) accuracy-related penalty with

regard to the deduction claimed for consulting fees paid to SCS for

the fiscal year ending May 31, 1990, as determined by respondent.

To reflect the foregoing,

Decisions will be entered

under Rule 155.