Court Opinion

ID: 4490371
Source: CourtListenerOpinion
Date Created: 2020-01-17 22:02:20.375203+00
Date Added: 2024-06-11T15:02:13.699134
License: Public Domain

Phillips,
dissenting: I can not agree with the method used in the majority opinion in computing earned surplus for invested capital purposes. By section 826 (a) of the Revenue Act of 1918 invested capital is defined to include:
(1) Cash paid in for stock or shares;
(2) Cash value of tangible property paid in for shares;
(8) Paid-in or earned surplus;
(4) Cash value of intangible property paid in for shares.
There are certain limitations with which we are not now concerned. There is one, however, which lies at the base of the present controversy. Section 831 provides that in the case of a change of ownership of a trade or business, or of property, after March 3, 1917, if an interest or control of 50 per centum or more remains in the previous owners and such owners are not corporations, then any asset transferred or received from such previous owner shall, for the purpose of determining invested capital, be taken at its cost of acquisition to the previous owners.
The question involved in the instant case may be more easily understood if a less complicated but comparable set of facts be stated. Assume that A owned a patent which he had perfected at a negligible cost. After March 3, 1917, he transferred it to X corporation, which issued therefor all its capital stock to A. At the time of the transfer the patent had an actual cash value of $16,000 and a remaining life of sixteen years. X corporation immediately leased the patent for a royalty of $4,000 per annum. Out of such royalty, which is its only income, X corporation sets up a depreciation reserve of $1,000 per annum and distributes the remaining $3,000 per annum to its stockholders.
At the end of the first year the patent, after deducting the depreciation reserve, will be earned as an asset at $15,000 and X corporation will have $1,000 in cash. Each succeeding year will see the patent value reduced by $1,000 and an increase in cash of a cor*672responding amount. At the end of the sixteen-year life of the patent, X corporation will have $16,000 in cash but no patent.
By reason of section 331 the patent can not be included in invested capital except at its cost to A, which was nominal. It therefore follows that for the first year X corporation has no invested capital. Is this also true for the succeeding years ?
Except for the provisions of section 331, the patent could have been included in invested capital at $16,000. The phrase which excludes it is that the value of “ any asset so transferred ” shall be taken at cost to the previous owner. The limitation applies only to the asset transferred and not to the proceeds which may be realized from its sale or set aside from earnings to cover its exhaustion. In either such case the asset in question has been sold, in whole or in part, and the purchase price remains in the business, either in the form of cash or other assets. The limitation on the asset sold does not apply to the new asset and invested capital should be so computed as to include the cost of this new asset — -not the value at which the old asset could have been included. Beading sections 326 and 331 together, it seems to me that the limitation imposed by 331 applies only so long as the corporation continues to hold the asset received from the former owner, and has no application when such asset is disposed of and the proceeds reinvested.
It may be taken for granted that before a corporation can have earnings or an earned surplus, provision must be made to keep its capital intact. But before this may be done, we must know what this capital is and what amount it is that we must make provision to recover out of earnings. The base may vary under different circumstances and for different purposes. The difficulty in computing-invested capital in the case before us, or in the case stated above, lies in the different values or bases assigned the assets in question for different purposes. For one purpose their value is fixed at their cost to a preceding owner; for another purpose, at their value when received by the corporation. Some idea of the varying bases which are used in the income-tax acts for different purposes may bo gathered from reading section 202 as it appears in the Revenue Acts of 1921,1924, and 1926 and pondering upon the changes made.
Where, as here, the statute limits the amount at which an asset may be included in capital and in the same section provides for the inclusion of earned surplus, I am of the opinion that a proper construction of-the statute requires that earned surplus be computed upon a basis consistent with the capital value used.
In computing earned surplus for invested capital purposes, the earnings need only be reduced by a depreciation reserve sufficient to recover the value assigned to capital assets for the same purpose, *673and we need have no regard for the valu§ which may be assigned such capital assets for other purposes. In the case stated at the beginning of the opinion, the patent is allowed no value for invested capital purposes; there is no capital value to be recovered and, in computing earned surplus for invested capital purposes, earnings are not to be reduced to provide a reserve for depreciation or exhaustion. The fact that the patent has a different capital value for a different purpose and that a reserve for depreciation or exhaustion of such value is necessary for such other purposes is immaterial, in my opinion. I should compute invested capital, contrary to the conclusion reached in the majority opinion, upon the theory that earned surplus was to be computed consistently with the basis of value assigned to capital assets for invested capital purposes. In the theoretical case stated at the beginning of the opinion, my conclusion would be that X corporation had invested capital of $1,000 for the second year, $2,000 for the third, and $16,000 for the year after the life of the patent had expired. I recognize that in commercial accounting it would bo considered that X corporation had no earned surplus at any time, but this is only because in such accounting it had at all times a capital of $16,000 which it was bound not to impair. For invested capital purposes it had no capital, and therefore its earnings were all a part of its earned surplus or undivided profits. I believe that this situation was recognized and is covered by article 844 of Regulations 45, quoted in the prevailing opinion. I do not consider Willcuts v. Milton Dairy Co., 275 U. S. 215, as having considered the question now before us. Nor is the conclusion which I reach contrary to LaBelle Iron Works v. United States, 256 U. S. 377. No increased value 'is assigned to the patent. Either one of two things has happened, depending upon the approach made to the question. The patent, which had no value for invested capital purposes, has been realized upon by a sale of a portion thereof (Ludey v. United States, 274 U. S. 295) and the proceeds are represented by cash, or there have been earnings which go into invested capital in toto as earned surplus, without any reduction for exhaustion of an asset having no value for invested capital purposes.
So far I have discussed a stated case in which the reserve for depreciation or exhaustion of capital assets was held in cash, where there was only one asset and where that asset had no value for invested capital purposes. But this has been only to simplify the problem presented. It is immaterial that the reserve set up out of profits may not be in cash but may be reinvested in other assets of the company, or that there were many depreciable assets instead of only one, or that, instead of no value, such assets had a substantial *674value but nevertheless a^value less for invested capital than their actual value when received. The principle is the same. In computing earned surplus for invested capital purposes, earnings should be reduced only by an amount sufficient to keep intact the value at which the capital assets are included in invested capital, and not by an amount necessary to keep some other value unimpaired. To the extent that the reserve for depreciation exceeds an amount necessary to keep the original invested capital unimpaired, it is a part of the earned surplus to be used in computing invested capital. For these reasons I disagree with the conclusion reached upon what is termed the fourth issue in the prevailing opinion.
McMahon agrees with this dissent.