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operatives are required to report patronage dividends paid to farmer members, so the Internal Revenue Service may hound the farmers and make them pay individual income tax on dividends which they have not received in casb money and may never receive. Third, it would put cooperative corporations and their members and stockholders on a single-tax basis, instead of the double tax that other corporations and their stockholders are now required to pay. And fourth, this proposal would bring into the Treasury of the United States at least $400 million of new revenue.
The members of the Senate Finance Committee are fully aware of the tremendous growth in volume of cooperative business; of its expansion into practically all lines of enterprise, many of them far removed from the farmer's needs for marketing or purchasing; and of the complaint of businessmen and other taxpayers because of the tax privileges which are granted to cooperative competitors.
Now, while the revenue code is being rewritten, is the time to correct this situation. H. R. 5598 is, in the opinion of many persons, the fairest and best way to do it. Sections 521 and 522 of H. R. 8300 are, to all intents and purposes, identical with subsections 12 and 13 of section 101 of the present Internal Revenue Code. My bill, H. R. 5598, proposes that these sections be eliminated from the code, thereby doing away with the present legal exemption of cooperative corporations from payment of Federal income tax on their earnings. Further, I would insert at the proper place in the code a definition of the cooperative corporation as a taxable entity, and, to the end that there could be no misinterpretation of the intent of the new law, I would explicitly terminate the present deduction of patronage dividends from the net income of the cooperative corporation.
In other words, a cooperative corporation would then be treated, for tax purposes, in exactly the same manner as any other corporation.
I have gone further, however, in suggesting a provision that is, I am convinced, highly desirable as a measure of just and additional relief for our farmers.
Treasury regulations have always insisted that the farmer-members of cooperatives should report their patronage dividend receipts and pay income tax on them. Until 1951, however, there was no effort to enforce this regulation and consequently it was, I believe, generally ignored. In 1951 Congress wrote into law a binding requirement that co-ops report the patronage dividends paid to members so the Internal Revenue Service can check up on our farmers' individual income-tax returns and force them to pay income tax whether they have received their dividends in cash, in stock, in scrip, in merchandise, by book allocation, or by any other so-called constructive method. All this means that in probably 9 cases out of 10 the farmer will have to dig down into his pants pocket for money earned by the sweat of his brow to pay the tax on patronage dividends that he may never get in cash so long as he lives.
That, I insist, is an evil conception of taxation. It should be corrected so that the farmer may be freed from this unwarranted burden and the cooperative corporation be made to pay the tax and give a credit to the farmer or city member. Then, instead of an addition to his tax, he might well have a subtraction.
That is just what H. R. 5598 proposes to do. That primarily is why it should be included in the Senate's version of H. R. 8300. The farmer is being hurt. He should be given relief—but the tax should be paid nevertheless. The cooperative corporation should pay it—no one else.
The revenue to come from enactment of legislation such as I propose would be a very considerable sum. My own figure of $400 million or more would go some way toward making up the losses resulting from other features of the bill as it stands.
My proposal will bring justice to competitive businesses, relief to farmers, and new revenue to the Treasury. I urge its immediate consideration and its inclusion in H. R. 8300.
The CHAIRMAN. All right, Mr. Balluff.
STATEMENT OF E. J. BALLUFF, CHAIRMAN, SPECIAL COMMITTEE
ON TAXATION, AMERICAN PATENT LAW ASSOCIATION
Mr. BALLUFF. Mr. Chairman, my name is Edwin J. Balluff. I am a patent lawyer. I have my offices in the city of Detroit, Mich. I am appearing here as chairman of the special committee on taxation of the American Patent Law Association, to express its views on section 1235 of H. R. 8300, with reference to the sale or exchange of patents by an inventor. We are pleased to have this opportunity to express our views.
I would like to file the report of the special committee on taxation of the American Patent Law Association, together with an accompanying memorandum, which is a collection of cases having to do with the question of capital gains tax treatment of patents by the courts.
The CHAIRMAN. It will be put into the record.
REPORT BY E. J. BALLUFF, CHAIRMAN OF THE SPECIAL COMMITTEE ON TAXATION
OF THE AMERICAN PATENT LAW ASSOCIATION ON SECTION 1235 OF H. R. 8300_ INTERNAL REVENUE CODE OF 1954
This section proposes for the first time special consideration in the tax laws of revenue derived from patent rights. In reporting the new tax bill, H. R. 8300, the Committee on Ways and Means of the House of Representatives with reference to this section stated that it would obviate the distinction under present law between amateur and professional inventors with respect to capital gain treatment of income from the sale of patent rights. The committee also reported that this section would “provide a larger incentive to all inventors to contribute to the welfare of the Nation,” and was “applicable equally to all inventors, whether amateur or professional, regardless how often they sell their patents.”
The special committee on taxation of the American Patent Law Association endorses such policy of offering greater incentive to all inventors to contribute to the welfare of the Nation, and the elimination of the distinction between socalled amateur and professional inventors, but has serious doubts that the section as worded would actually further this policy and therefore has voted to disapprove the section in its present form.
Section 1235 as worded would enable inventors (but not assignees) to treat the gain from a sale or exchange of a patent or application therefor or an interest therein as a capital gain if, and only if, the seller retains no interest in the patent rights sold, and if the entire proceeds are received within a period of 5 years from the date of such sale or exchange.
While section 1235 makes no distinction between so-called amateur and professional inventors, it materially limits the established rule of the Myers case (6 T. C. 258 (1946)) which has been generally followed by the courts but has not been acquiesced in by the Bureau of Internal Revenue. In the Myers case the Tax Court of the United States held that an exclusive license under which the licensee agreed to pay stated percentages in royalties was a sale of the invention even though the license was subject to a condition subsequent which permitted either the licensee or the licensor to cancel, and the inventor was permitted to treat the gain reecived as a sale of a capital asset within the meaning of section 117 (a).
In March 1950, the Commissioner of Internal Revenue withdrew his previous acquiescence in the Myers case and announced that for income-tax purposes the Bureau would tax royalties as ordinary income where in consideration of the assignment of a patent or of an exclusive right thereunder the assignee or licensee agreed to pay an amount measured by production, sale or use, or amounts payable periodically over a period generally coterminous with the transferee's use of the patent. However, prior to the Commissioner's statement of nonacquiescence in the Myers case, the method of payment was accorded little weight in determining whether the revenue from the transaction was entitled to capital gains treatment.
Thus, at the present time the tax treatment of situations like that in the Myers case is generally viewed in one light by the courts and in an opposite light by the Bureau, since the Bureau has had little success in getting its nonacquiescence doctrine generally adopted by the courts.
The report of the Committee on Ways and Means with reference to section 1235 leaves the impression that under current law a party could not obtain capital gains tax treatment under an exclusive license arrangement where the licensee agreed to pay royalties measured by production, sales, or use, and that section 1235 now for the first time makes this possible if the entire proceeds are received within a period of 5 years from the date of such sale or exchange, whereas under exclusive license arrangements of the type involved in the Myers case, which are quite common, royalties equal to a percentage of the selling price of the articles manufactured and sold are generally given capital gains tax treatment by the courts if not excluded by section 117 of the present act.
The report of the Committee on Ways and Means with reference to section 1235 also creates the impression that under existing law only inventors, and then only amateur inventors, can obtain capital gains tax treatment, whereas the fact is that any party—that is, an inventor, an assignee, or a corporation, who can qualify under section 117 is entitled to capital gains tax treatment under the doctrine of the Myers case. For example, an assignee or a corporation who sells or exclusively licenses a patent is entitled to capital gains tax treatment if the property sold is not excluded by the subdivisions of section 117.
It is unfortunate that the report of the Committee on Ways and Means employed the term “amateur” to indicate the type of inventor now entitled under the law to capital gains tax treatment because the cases show that it is now possible for a professional inventor to qualify for capital gains tax treatment under certain conditions.
Section 1235 as worded may be availed of by an inventor only if he retains no interest whatever in the patent right transferred except to the extent that the purchase price may be related to the productivity, use or disposition of the property transferred within a period of 5 years from the date of the sale or exchange and if the entire proceeds are received or payable within such period of 5 years. Such prohibition against retention of interest would automatically exclude the usual exclusive license arrangements which are now held by the courts to be tantamount to a sale. In the usual exclusive license arrangement the licensor retains title but grants to the licensee the exclusive rights subject to the obligation to pay royalties, usually conditioned upon the extent of use of the invention. Exclusive license agreements frequently include conditions subsequent which permit termination of the license by the licensor or the licensee. Notwithstanding this, the doctrine of the Myers case recognizes an exclusive license of this type as being tantamount to a sale and as entitling the licensor to capital gains tax treatment if the taxpayer is not precluded by reason of the subdivisions of section 117.
The requirement in section 1235 that the entire proceeds of the sale or exchange must be received or payable within a period of 5 years from the date of the sale or exchange would also for practical purposes generally preclude the posibility of making a deal which would be entitled to capital gains tax treatment. Patents are issued for a period of 17 years after pending in the Patent Office for a period which usually lasts several years. The value of a patent can be seriously affected by obsolescence, invalidity, the successful designing around the patent so as to avoid infringement thereof, and a number of other factors. Generally speaking, it would be practically impossible in many cases for an inventor and a prospective purchaser or exclusive licensee to agree on the amount which must be paid to the inventor within a period of 5 years to permit the use by the licensee or the assignee of the invention over the full life of the patent. This would be particularly true for an important invention ! The existence of two or more patents which would have to be included in such a deal, as frequently happens, would further complicate the problem.
It is also quite usual in connection with the sale or exclusive licensing of patents that the assignor or licensor be required to include improvements which may be made within some determinable period in the future. Since these improvements are not yet in being, it would be practically impossible to arrive at any evaluation thereof at the time that the sale or exclusive license is made. As there is no way of evaluating the actual worth of improvements in any kind of deal which must be paid out in 5 years, the inventor would be forced to forego capital gains tax treatment of the proceeds if he desired to be paid for such improvements, and improvements are frequently of real value, particularly in the case of experienced inventors whose ability makes them peculiarly well qualified to try to anticipate today the problems of tomorrow.
It also frequently happens in the case of a sale or exclusive license that two or more patents which issued years apart may be included in the deal, one of them being perhaps somewhat basic and the other perhaps a specific improvement which is thought to be particularly well suited for commercial exploitation. The relative value of these patents may be difficult if not impossible to determine, but because of the 5-year limitation in section 1235 an inventor, if he were desirous of getting for the sale or exclusive license of his patents an amount equal to their worth, would, generally speaking, be forced to make a deal which would not qualify under section 1235. The value of a patent is determined to an appreciable extent by its relation to the business protected by it and/or by the extent to which the invention is used in such business. While a patent's life is 17 years, the useful life of a patent may be less than 17 years, and may come at any time during the 17-year period. The actual worth of a patent may well not be proved during the first 5 years after the making of a deal.
It also sometimes happens that an inventor in order to make a deal looking toward the commercial exploitation of his patent must acquire a patent right from another inventor, which is included as a part of the deal. Section 1235 would be inapplicable to a patent right in the hands of a person other than the inventor and yet it would be difficult if not impossible to allocate the value as between the purchased patent right and that of the inventor in such a deal.
Practical problems in arriving at a fixed valuation for the sale of patent rights probably were one of the principal reasons for the development of the exclusive license type of arrangement which permitted the licensee to enjoy fully the benefits of the patent and to pay for the same in accordance with the extent of use thereof over the life of the patent.
The foregoing demonstrates that the wording of section 1235 is quite inapplicable to exclusive license arrangements, and if section 1235 is adopted as now worded it will as a practical proposition exclude most patent sales or exclusive license arrangements from capital gains tax treatment.
Section 1235 as worded would even exclude from its benefits a corporation wholly or largely owned by an inventor for the purpose of exploiting his own inventions.
As section 1235 is applicable only to an inventor and provides the only method under the new code whereby the inventor of a patent can obtain capital gains tax treatment on its sale, it appears in view of the foregoing that those inventors whose exclusive licenses can now qualify under the Myers decision will be in a much worse position than at present.
Since section 1235 deals specifically with patents but is applicable only to inventors, the following possibilities are suggested :
1. By excluding assignees is it contemplated they shall be denied capital gains tax treatment in all cases? Some have so construed section 1235.
2. As section 1235 excludes only inventors from qualifying under section 1221, is it intended that an assignee might qualify for capital gains tax treatment under section 1221 under the doctrine of the Myers case for example and on more favorable terms than those available to an inventor under section 1235? This could permit an assignee owner of an undivided interest in a patent to obtain capital gains tax treatment while the inventor would be denied such favorable treatment.
If section 1235 does not affect capital gains tax treatment of assignees as strongly urged by many, then it appears that section 1235, which is designed to provide a larger incentive to all inventors to contribute to the welfare of the Nation, actually gives them less favorable tax treatment than they now enjoy and less favorable than that which would be enjoyed by assignees under section 1221. To say the least, this seems quite unrealistic.
Patents are the legal vehicles by means of which inventions are converted into property rights. The Constitution, by giving Congress the power to promote the progress of science and the useful arts by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries, recognized the importance of encouraging activity which is productive of inventions for the benefit of the public at large.
Very recently, the Supreme Court in referring to such constitutional provision stated :
“The economic philosophy behind the clause empowering Congress to grant patents and copyrights is the conviction that encouragement of individual effort by personal gain is the best way to advance public welfare through the talents of authors and inventors in ‘science and useful arts. Sacrificial days devoted to such creative activities deserve rewards commensurate with the services rendered.”
The policy expressed by the Committee on Ways and Means as a premise for the enactment of section 1235 to “provide a larger incentive to all inventors to contribute to the welfare of the Nation” is an affirmation of the philosophy behind the constitutional basis for patents.
Inventors are benefactors of the public because after the expiration of a patent, the invention covered thereby is available for the free use of the public. However, since patents protect inventions for a limited time, they make possible the establishment of industries and businesses which are vitally important to the economic welfare of the country as a whole.
For the reasons pointed out, section 1235 as now worded is wholly inadequate to encourage inventive activity and the expenditure of funds to support the same. In fact, in many respects it seems to be a step backward and perhaps places inventors in a worse position than their financial backers. Because of the substantial expense necessarily involved in carrying on the type of work which is productive of inventions, it is vitally important that inventors and their financial backers he accorded such favorable tax considerations as will further stimulate inventive activity and the expenditure of funds in support thereof. The risks and uncertainties of the return involved in activities of this kind require that real and substantial recognition be accorded by the tax laws to inventors and their financial backers.
It is our belief that any tax incentive to be effective as a stimulus to inventive activity and the expenditure of funds required to support the same necessitates the removal of the 5-year limitation and the prohibition against retention of any interest. With these modifications, the section should also be revised to make it applicable to all gain from the sale, exchange or licensing of patent rights. Furthermore, assignees who usually furnish the required funds, as well as inventors, shou'd be entitled to the same favorable tax considerations.
As an indication of the extent to which special tax treatment should be given to encourage inventive activity, the special committee on taxation of the American Patent Law Association has heretofore approved H. R. 7645, which proposed to amend section 117 of the present Internal Revenue Code to provide that revenue from the sale or license of patents should be treated as capital gains. It has also approved H. R. 7646 which proposed to amend the present Internal Kevenue Code to provide a depletion allowance against income obtained from patents. These approvals of the special committee on taxation with reference to H. R. 7645 and 7646 have been approved by the board of managers of the American Patent Law Association.
MEMORANDUM SUBMITTED BY E. J. BALLUFF, CHAIRMAN, SPECIAL COMMITTEE ON
TAXATION, AMERICAN PATENT LAW ASSOCIATION The following tax decisions follow the doctrine of Edward C. Myers v. Commissioner (6 T. C. 258) respecting capital gains tax treatment of royalties under exclusive license agreements: William M. Kelley v. Commissioner (6 T. C. M. 646, June 12, 1947). Kimble Glass Co. v. Commissioner (9 T. C. 183, Aug. 14, 1947). Raymond W. Hessert v. Commissioner (6 T. C. M. 1190, Oct. 31, 1947). Elrod Slug Casting Machine Co. v. Commissioner (7 T. C. M. 157, Mar. 26, 1948). Carl G. Dreymann v. Commissioner (11 T. C. 153, Aug. 9, 1948). Hofferbert v. Briggs (50–51 U. S. T. C. 178, F. (20) 743 C. A. 4, Dec. 21, 1949). Thompson v. Johnson (50–51 U. S. T. C., DCSD NY, July 26, 1950). Halsey W. Taylor v. Commissioner (16 T. Č. 376, February 19, 1951). Lamar v. Granger (99 F. Supp. 17, D. C. Pa., July 3, 1951). Wilma M. Imm v. Commissioner (11 T. C. M. 258, Mar. 24, 1952). Herbert Allen v. Commissioner (11 T. C. M. 1093, Nov. 12, 1952). Carruthers v. U. S., (53–51 U. S. T. C. p. 9316, D. C. Oregon, March 3, 1953). Arthur C. Cope (12 T. C M. 525, May 15, 1953). General Spring Corp. (12 T. C. M. 847, July 27, 1953).
Corporate licensor given capital gains tax benefits.
The following decisions follow the doctrine of the Myers case, but are more liberal than Myers from the viewpoint of the taxpayer : Kavanagh v. Evans (188 F. (20) 234 C. A. 6, decided Apr. 9, 1951).
The agreement stated that the license was nonexclusive as to certain of the subject matter, and the licensor retained the right to manufacture, use, or sell the licensed device when designed for a specific use. Allen v. Werner (190 F. (20) 840 C. A. 5, decided July 13, 1951).
The license granted the exclusive right to make and sell, but failed to grant the right to use. The licensee was prevented from assigning its interest except in connection with sale of the entire business. Parole evidence was admitted