SUPPLEMENT 1

DIVISIBILITY IN RELATION TO INCOME TAX

(By Lorna G. Margolis)

Historically, the doctrine of divisibility or indivisibility of copyright, i.e., whether a transfer of one of the "bundle of rights" comprising a copyright is a sale or merely a license, has played a key role in determining whether income from copyrighted material is taxable as capital gains or ordinary income. The latter, of course, means a higher For the purpose of taxation, a creative artist is a tradesman; his activities are as much subject to taxes as the ordinary businessman's. While in the case of a resident writer, it is to his advantage that income from his works be treated as capital gains, since the tax is lower; it is even more to the advantage of a nonresident author, since the income from the sale of a capital asset of a nonresident author is completely free from tax. Thus, taxwise, it is to the advantage of a copyright owner that the proceeds from a copyright be treated as capital gains. The important question is whether the transfer of one of the "bundle of rights" comprising a copyright is treated for tax purposes as a sale of a capital asset or a license of income-producing property.

Other factors besides the divisibility or indivisibility of copyrights have been and are important in determining whether income from copyrights is treated for tax purposes as capital gains or ordinary income. These other factors will also be considered in this paper, in order to appraise the importance of divisibility in this determination.' There is the same lack of unity in the court decisions involving taxes on the transfer of less than an entire copyright that there is in other aspects of the indivisibility theory. Added to this is the confusion. brought about by varying Internal Revenue rulings, some of which were based on continual changes in the legal connotation of the indivisibility theory.

For instance, in 1921, the Bureau of Internal Revenue had issued its office decision ia holding that receipts from the absolute transfer by a nonresident alien of the rights to a serial publication in the United States of certain literary works were not derived from a source in the United States, because the transaction constituted a sale and not a license for use. In 1925, the Treasury held that an author's sale of the movie rights to his play fell within the category of the sale of a capital asset. Subsequently, however, this ruling was repudiated by I.T. 2735, XII-2 Cum. Bull. 131 (1933), in which the Treasury stated that a copyright constitutes a single unit of property and that grants of anything less than the whole were licenses merely, and the amounts paid for them were royalties to be taxed as ordinary income.

1 There are, of course, various devices by which a copyright owner may reduce the amount of the taxes on the income from his copyrights. For example, he may transfer a part of the copyright, such as motion picture rights or an undivided interest in the entire copyright, to another member of his family who will pay taxes at a lower rate. Such devices for reducing the amount of taxes are not within the scope of this paper; la OD 988, 5 Cum. Bull. 117 (1921).

I.T. 2169, IV-1 Cum. Bull. 13 (1925).

3

This ruling is in line with the Sabatini case. There, the taxpayer was an alien writer. The income sought to be taxed was that received under contracts covering (1) volume and second serial rights; (2) motion picture rights; and (3) dramatic rights. Judge Chase, speaking for himself and Justices Learned Hand and Augustus N. Hand, held that as to (1), the percentage payments on the number of volumes sold fell within the gross income contemplated by the then section 119(a)(4) of the Internal Revenue Code which provided that taxable income includes:

Rentals or royalties from property located in the United States or from any interest in such property, including rentals or royalties for the use of or for the privilege of using in the United States, patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises and other like property.

As to (2), since the author granted an exclusive worldwide right to produce motion pictures based on five of his works for a stated period, the author remained the owner of his works and merely licensed their use for a particular object for a period. There was no transfer of title necessary to a completed sale. Even though in a lump sum, the payment was for the purpose of using a literary property in the United States and was held taxable as a royalty paid in advance. As to (3), the income from sale of dramatic rights to "Scaramouche" was held to be payment for licensing, and therefore taxable as income.

The indivisibility doctrine was undoubtedly strengthened by this decision, as it was by the Board of Tax Appeals in the case of Irving Berlin v. Commissioner and Ehrlich v. Higgins. In the first case, the Board of Tax Appeals cited the Sabatini decision with approval and treated the contract in which Berlin agreed to write songs for a motion picture, the copyrights to be taken out in Berlin's name and certain rights to be reserved to Berlin, as a license and not a sale; the proceeds to be taxed as ordinary income for personal services. In the Ehrlich case, the proceeds from a contract for the use of certain material for a limited time for a motion picture, the family to retain all other rights in connection with the material, were also held to be ordinary income, since only "use" rights were transferred, which did not constitute a "sale.'

In the case of Goldsmith v. Commissioner of Internal Revenue, the indivisibility doctrine was upheld by Justice Chase and rejected by Justices Learned Hand and Swan. In this case, Goldsmith had reported as capital gains, resulting from the sale of capital assets, payments made to him by Paramount Pictures Corp. for the exclusive motion picture rights in a play he had written. The Commissioner, however, treated such payments as ordinary income, taxable at ordinary income rates. The Tax Court sustained the Commissioner on the ground that the transaction was not a sale, and that, even if it had been a sale, it was not the sale of a capital asset as that term is

Sabatini v. Commissioner of Internal Revenue and Commissioner of Internal Revenue v. Sabatini, 98 F. 2d 753 (2d Cir. 1938).

442 BTA 668 (1940).

52 F. Supp. 805 (D.C.N.Y. 1943).

143 F. 2d 466 (2d Cir. 1944).

defined in section 117(a)(1) of the Revenue Act of 1938 7 since the property was used in trade or business and was subject to an allowance for depreciation. Under this section, proceeds from the sale of a depreciable asset, used in trade or business, were taxable as ordinary income. On appeal by Goldsmith, Judge Chase, in affirming the Tax Court, cited the copyright cases upholding the indivisibility doctrine, as well as the Sabatini case, saying:

*** If he (assignee) gets only the rights of a licensee, the so-called assignment amounts only to a license *** And when that is so, the amount which the assignee pays for what he gets is for tax purposes to be treated as ordinary income to the recipient because it is in fact royalty income. Unless the assignment conveys to the assignee the copyright, no sale of property is made. [Emphasis supplied.]

9

It is, of course, not surprising, in view of his decision in Photo Drama Motion Picture Co. Inc. v. Social Uplift Film Corp., that Justice Learned Hand, while agreeing in the outcome, did not agree with Judge Chase's reasons. Judge Learned Hand, with the approval of Judge Swan, rejected the indivisibility theory, as follows:

*** Nor does it seem to me to be material that the exclusive license which the author granted to the Paramount Co. did not convey "title" to either [copyrighted or literary property], as I assume it did not. I do think that both were "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." Clifford Goldsmith was "in business" as a playwright. *** Although he had written only one play, he spent his time in exploiting it in various ways ***. This he did by licenses to producers of a stage play, by licenses to broadcasters and by licenses to moving picture producers, whose proceeds are here in suit ***. An exclusive license requires the author to protect the licensee against infringement, and is for most purposes treated as "property." I think it is "property" within Section 117(a) (1); that its grant is a "sale" and that the licensee is a "customer" in the ordinary course of business when the author is in business.

Section 117(a)(1) of the Internal Revenue Code of 1939 specifically excludes "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business" from the definition of the term "capital assets." 10

The case of Rohmer v. Commissioner of Internal Revenue 11 was another case decided upon the theory of indivisibility of copyright. In that case, a nonresident alien sold the American and Canadian serial rights in one of his stories, "Island of Fu Manchu," to Liberty magazine for $10,000, retaining all other rights. The taxpayer contended that the proceeds were capital gains because payment was made in a lump sum and the magazine acquired in toto a specific part of the author's "bundle of rights"; thus, he contended, payment was

'Section 117(a)(1) of the Revenue Act of 1938 reads as follows:

"SECTION 117. CAPITAL GAINS AND LOSSES.

"(a) DEFINITIONS.-As used in this title

"(1) CAPITAL ASSETS.-The term 'capital assets' means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the trade or business, of a character which is subject to the allowance for depreciation provided in Section 23(1); (Section 23(1) defines, as one of the deductions from gross income, "DEPRECIATION.-A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence * *."')

Goldwyn Pictures Corp. v. Howells Sales Co., 282 Fed. 9 (2d Cir. 1922); M. Witmark & Sons v. Pastime Amusement Co., 298 Fed. 470 (D.C.E.D.S. Car. May 1924), aff'd. 2 F. 2d 1020 (4 Cir. Dec. 1924). 220 Fed. 448 (2d Cir. 1915).

10 See note 7 supra.

11 153 F.2d 61 (2d Cir. 1946).

not a "royalty" under section 211(a)(1)(A),12 but payment of the purchase price on a sale of personal property. If his contention were upheld, he would have to pay no taxes on the proceeds of the sale of these serial rights, since a 1936 amendment to the Internal Revenue Code excluded from taxation the proceeds of sales by nonresident aliens not engaged in trade or business in this country and not having an office or place of business here.18

Judge Frank, however, held that—

* where a copyright owner transfers to any particular transferee substantially less than the entire "bundle of rights" conferred by the copyright, then payment therefor, whether in one sum or in several payments, constitutes royalties within the meaning of section 211(a)(1)(A). For such a transfer is the grant of a license**

In referring to the opinion of Justices Learned Hand and Swan in the Goldsmith case, Judge Frank indicated that their decision was rendered on an interpretation of section 117 of the 1938 act,1 which has a different history and purpose than section 211(a)(1)(A). Judge Frank remarked, in this connection that

it is well to remember that the concepts employed in construing one section of a statute are not necessarily pertinent when construing another with a distinguishable background.

When P. G. Wodehouse, a nonresident alien author sold several of his stories in 1938 and 1941 to a magazine publisher, for a lump sum, under which the magazine was to obtain the copyright and reassign all but the serial rights to the author on demand, Wodehouse claimed the income did not fall within the purview of section 211(a)(1)(A) for the following reasons:

1. Because it was received in payment for personal property sold by him; and

2. Because the payments were not made in annual or periodical amounts as described in the statute but in a lump sum.

The Fourth Circuit repudiated the decision of the Second Circuit in the Rohmer case and agreed with Mr. Wodehouse on both counts, Judge Soper saying:

*** serial rights, book rights, dramatic production rights and motion picture rights of a literary production are property rights which may be and are separately and effectively bought and sold in the literary market *** the authorities cited in Rohmer v. Commissioner on the indivisibility of the copyright do not 12 "SEC. 211. TAX ON NONRESIDENT ALIEN INDIVIDUALS. "(a) No UNITED STATES BUSINESS OR OFFICE.

"(1) GENERAL RULE.

"(A) IMPOSITION OF TAX.-There shall be levied, collected, paid for each taxable year, in lieu of the tax imposed by sections 11 and 12, upon the amount received, by every non-resident alien individual not engaged in trade or business within the United States and not having an office or place of business therein, from sources within the United States as interest (except interest on deposits with persons carrying on the banking business), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income, a tax of 15 per centum of such amount." 53 Stat. 75, 54 Stat. 518. (Although this section does not specifically mention "royalties," "rentals or royalties for the use of *** copyrights" is included in Section 119, which defines the items of gross income that shall be treated as income from sources within the United States, and Treasury Regulations have interpreted Section 211(a)(1) (A) to include "rentals or royalties for the use of copyrights.")

18 The 1936 amendment excluded the proceeds of sales, theretofore taxed, from the taxable incomes of nonresident aliens not engaged in trade or business in this country and not having office of place of business here. At the time of enacting that amendment, the Congressional Committee Reports stated that the purpose was to tax "gross income from interest, dividends, rents, wages, and salaries and other fixed and determinable income," but that, by the amendment, "the tax on capital gains of such aliens was to be excluded, it having been found impossible to effectively collect this latter tax * *."

14 In the Goldsmith case, Justices Hand and Swan held that it was immaterial whether "title" passed; that the grant of an exclusive license was a "sale," but not of a "capital asset," as defined in Section 117(a) (1), because the license was "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." See note 7, supra, for the contents of Section 117(a)(1).