Citation Codes

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Docket Number

Nos. 11246-11248.

Attorney(S)

Joseph F. McVeigh, Philadelphia, Pa. (Thomas M. Cooley, II, and Henry B. Weaver, Jr., Washington, D.C., Francis J. Myers, Cornelius C. O'Brien, Philadelphia, Pa., on the brief), for petitioners. Alonzo W. Watson, Jr., Washington, D.C. (H. Brian Holland, Asst. Atty. Gen., Ellis N. Slack, Robert N. Anderson, Sp. Assts. to Atty. Gen., on the brief), for respondent.

Judges

Harry Ellis Kalodner

Acts

Internal Revenue Code — Income Taxes — Normal Taxes And Surtaxes — Determination Of Tax Liability — Credits Against Tax — Nonrefundable Personal Credits — Adoption Expenses

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Smart Summary

Summary of Opinion: Urquhart et al. v. Commissioner of Internal Revenue (3d Cir. Aug. 24, 1954)

Factual and Procedural Background

The Tax Court had determined that certain litigation expenses incurred by taxpayers were capital in nature (20 T.C. 944). The taxpayers (George Gordon Urquhart, Radcliffe M. Urquhart and W.K.B. Urquhart), participants in a joint venture since 1939 engaged in inventing, developing and exploiting patents and licensing patents and processes, sought review of that determination for the 1946 taxable year. The joint venture's sole business from 1942 through 1946 was licensing two patents (Nos. 2,106,043 and 2,198,585) involving fire-fighting equipment, from which the venture realized substantial royalties.

In 1943 the patent owners threatened and initiated infringement litigation against a customer of an alleged infringer. Pyrene Manufacturing Company then brought a declaratory judgment action in May 1943 seeking declarations that the patents were invalid and that its apparatus did not infringe; a counterclaim sought an injunction and an accounting. The district court held the patents invalid in 1946; the Court of Appeals affirmed. In 1946 the taxpayers expended $55,748.64 in legal fees and expenses in connection with the litigation, which they deducted on the partnership and individual returns as litigation expenses. The Commissioner disallowed the deductions, treating them as capital expenditures. The Tax Court sustained the Commissioner, characterizing the litigation as defending a property interest (the exclusive patent rights) and treating the expenses as capital. The taxpayers appealed to the Third Circuit.

Legal Issues Presented

Whether the litigation expenses incurred by the taxpayers in patent litigation for 1946 were deductible as ordinary and necessary business expenses under Section 23(a)(1) (or (a)(2)) of the Internal Revenue Code or were capital expenditures to be capitalized as part of the cost of the patent (defense/perfection of title).
Whether the character of the litigation (infringement/declaratory judgment challenging validity) affects the classification of such litigation expenses as capital or ordinary and necessary business expenses.

Arguments of the Parties

Taxpayers' Arguments

The litigation expenses of $55,748.64 incurred in 1946 in patent litigation were ordinary and necessary expenses of their trade or business of exploiting and licensing patents.
Such expenditures constituted normal overhead or operating costs of their business and therefore were deductible under Section 23(a)(1) (or a(2)).

Respondent's (Commissioner) Arguments

The expenditures were capital in nature because they were incurred in defense or perfection of the equivalent of title (the exclusive right to make, use, and vend the inventions).
The Commissioner relied on Regulations 111, § 29.24-2 and the settled principle that expenditures for the defense or perfection of title are part of the cost of acquiring capital assets and thus should be capitalized.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Commissioner of Internal Revenue v. Heininger, 1943, 320 U.S. 467, 64 S.Ct. 249, 88 L.Ed. 171	Support that expenses can be ordinary and necessary even if unsuccessful; substance over form in tax characterization.	Used to show no decisive significance to taxpayers' lack of success and to support treating expenditures as ordinary and necessary business expenses.
Deputy v. DuPont, 1940, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416	Authority on ordinary and necessary business expense doctrine.	Cited as part of a group of cases establishing that such litigation expenses can be ordinary and necessary.
Welch v. Helvering, 1933, 290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212	General principle about ordinary and necessary business expenses and tax characterization.	Included among authorities supporting deductibility of the expenses as ordinary and necessary.
Kornhauser v. United States, 1928, 276 U.S. 145, 48 S. Ct. 219, 72 L.Ed. 505	Precedent concerning deductions for business expenses (cited in support of deductibility).	Cited in the court's conclusion that expenditures are within Section 23(a)(1) and deductible.
Bingham's Trust v. Commissioner, 1945, 325 U.S. 365, 65 S.Ct. 1232, 89 L.Ed. 1670	Rule that expense need not have produced income to be deductible as ordinary and necessary.	Relied upon to show that expenses need not be productive of income to qualify as current business deductions.
Thompson v. Commissioner of Internal Revenue, 3 Cir., 1953, 205 F.2d 73, 78	Principle that taxation focuses on substance over form.	Quoted to emphasize that substance prevails over form in tax characterization.
Paxson v. Commissioner of Internal Revenue, 3 Cir., 1944, 144 F.2d 772, 776	Support for substance-over-form approach in tax matters.	Used to reinforce the court's insistence on substance over form.
Berwind v. Commissioner of Internal Revenue, 3 Cir., 1943, 137 F.2d 451, 453	Authority on substance-over-form in taxation.	Used as another supporting citation for treating the reality of transactions as controlling.
Sinclair Carroll Co., Inc., v. Interchemical Corp., 1945, 325 U.S. 327, 330, 65 S.Ct. 1143, 89 L.Ed. 1644	Observation that defense of invalidity in patent litigation is normally raised and disposed of first.	Applied to explain that invalidity defenses are commonplace in infringement litigation and do not transform the litigation into a title dispute.
Rock-Ola Mfg. Corp. v. Cusano, 3 Cir., 1953, 206 F.2d 551, 553-554	Similar point about typical issues in patent infringement litigation.	Invoked to show the normal sequence and character of patent litigation issues (invalidity defenses).
Pyrene Mfg. Co. v. Urquhart, D.C.E.D. Pa. 1946, 69 F. Supp. 555	District court decision holding patents invalid (contextual precedent in the litigation history).	Referenced as the source of the district court's invalidity holding that led to the appealed expenditures.
Rassenfoss v. Commissioner, 7 Cir., 1946, 158 F.2d 764	That mere form of action is immaterial for tax purposes.	Cited to support the view that the declaratory judgment procedural posture did not alter the character of the controversy.
Mathey v. Commissioner, 1 Cir., 1949, 177 F.2d 259, 262	Discussion that awards of damages in patent litigation are ordinarily compensation for gains lost and taxable as income.	Quoted and used to explain the business character of patent litigation and how recovery relates to business income.
Duplate Corp. v. Triplex Safety Glass Co., 298 U.S. 448, 451, 56 S.Ct. 792, 793, 80 L.Ed. 1274	Authority quoted in Mathey regarding nature of profits to infringer and damages to patent owner.	Appears within the Mathey quotation to define terminology and nature of patent litigation recoveries.
Diamond Stone-Sawing Machine Co. of New York v. Brown, 2 Cir., 166 F. 306	Quoted in Mathey via Duplate on patent nomenclature (historical authority).	Cited within the Mathey quotation to support the characterization of patent damages/profits.
United Shoe Machinery Corporation v. Mathey, 1 Cir., 1941, 117 F.2d 331	Reference that in Mathey one of the patent claims was held invalid.	Cited to note that successful-patentee cases may nonetheless involve invalidity of certain claims; used in comparing fact patterns.
Commissioner of Internal Revenue v. Surface Combustion Corp., 6 Cir., 1950, 181 F.2d 444	Principle that expenditures yielding benefits over years are not current operating expenses.	Discussed and distinguished; court explained the principle but found it inapplicable to the facts here.
Safety Tube Corp. v. Commissioner, 6 Cir., 1948, 168 F.2d 787	Example where title to patents was involved and expenditures were deemed capital.	Used as an example of situations distinguishable from the present case because they involved title issues.
Falls v. Commissioner, 1946, 7 T.C. 66	Another example of expenditures deemed capital where title issues were involved.	Cited to illustrate distinguishable cases involving title disputes.
Hochschild v. Commissioner, 2 Cir., 1947, 161 F.2d 817	Authority supporting classification of similar expenses as deductible business costs.	Included among authorities the court relied upon to conclude expenditures were deductible under Section 23(a)(1).
Levitt Sons v. Nunan, 2 Cir., 1944, 142 F.2d 795	Authority cited in support of deductibility.	Used as supporting precedent for treating the expenses as ordinary business costs.
Appeal of F. Meyer Brother Co., 1926, 4 B.T.A. 481	Board of Tax Appeals decision relevant to classification of similar expenditures.	Cited as additional authority for the court's conclusion that the expenditures were current business expenses.
Urquhart v. American-La France Foamite Corp., 1944, 79 U.S.App.D.C. 219, 144 F.2d 542, certiorari denied, 1944, 323 U.S. 783, 65 S.Ct. 273, 89 L.Ed. 625	Prior appellate decision in the litigation history (context).	Referenced in the factual recounting of the litigation background.
Urquhart v. United States, 1953, 109 F. Supp. 409, 124 Ct.Cl. 441	Court of Claims decision in subsequent litigation (context).	Referenced to show further litigation history and outcomes (recovery denied on grounds of misuse).
National Foam System, Inc., v. Urquhart, D.C.E.D.Pa. 1952, 103 F. Supp. 433; affirmed, 3 Cir., 1953, 202 F.2d 659	Further litigation involving licensee and patentees (context).	Included in the factual history of related proceedings.
Pyrene Mfg. Co. v. Urquhart, supra (3 Cir., 1949, 175 F.2d 408)	Appellate affirmation of patent invalidity (context to litigation).	Referenced as part of the litigation outcomes that framed the taxable-year expenditures.
A.R.R. 98, 2 C.B. 105 (1920), Committee on Appeals and Review	Administrative advisory ruling treating post-patent litigation costs as operating expenses, not capitalizable.	Cited (in note) to show historical administrative position aligning with the court's conclusion that such litigation expenses are operating expenses.

Court's Reasoning and Analysis

The court began by stating the undisputed facts: the taxpayers were in the business of exploiting and licensing patents, the litigation arose in that business context, and the taxpayers incurred $55,748.64 in legal fees and related expenses in 1946 connected with patent litigation that ultimately resulted in adverse rulings on validity.

The court held that the expenditures were "ordinary and necessary" business expenses incurred in carrying on the taxpayers' trade or business and constituted normal overhead or operating costs. The analysis relied on established authorities to confirm that such litigation expenses may be ordinary and necessary even if unsuccessful, and that an expense need not produce income to be deductible.

The court addressed and rejected the Commissioner's characterization that the expenses were capital because they purportedly defended or perfected the equivalent of title to the patents. The court emphasized the substance-over-form principle in taxation and observed that the litigation was typical patent infringement litigation in which invalidity defenses are commonly raised and resolved early. It noted that no question of title or ownership of the patents was raised by Pyrene in its declaratory judgment action and that the taxpayers had initiated assertive conduct (threats and a suit against a customer) that led to the declaratory action—functionally similar to having commenced an infringement action themselves.

The court distinguished cases in which expenditures were capital—those involving removing a cloud on title or defending ownership of property—and stated that infringement litigation aimed at protecting the exploitation and licensing of a patent is different in character. The court relied on precedents (including Mathey and related authorities) to explain that patent litigation expenditures made to protect business profits are properly current business expenses. It also distinguished the principle that expenditures yielding benefits over several years are not current operating expenses, finding that principle inapplicable to these facts.

On balance, the court concluded the litigation expenditures were directly connected with and proximately resulting from the taxpayers' business activities and therefore deductible under Section 23(a)(1).

Holding and Implications

Judgment of the Tax Court reversed; cause remanded with directions to proceed in accordance with this opinion.

Implications:

The Third Circuit ruled that the $55,748.64 in litigation expenses incurred in 1946 by the taxpayers in patent litigation were ordinary and necessary business expenses deductible under Section 23(a)(1) of the Internal Revenue Code, rather than capital expenditures to be added to the cost of the patent.
The court emphasized that ordinary patent infringement litigation intended to protect exploitation and licensing of a patent is distinguishable from litigation whose primary purpose is to perfect or defend title; in the former situation expenses may be current business deductions.
No broad new doctrinal rule beyond the application of existing principles (substance over form; connection to business operations; distinction from title disputes) was announced; the direct effect is reversal of the Tax Court's capital-classification ruling and remand for proceedings consistent with this opinion.

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URQUHART et al. v. COMMISSIONER OF INTERNAL REVENUE, (two cases). URQUHART

KALODNER, Circuit Judge.

The Tax Court determined that certain litigation expenses were capital in nature. 20 T.C. 944 (September 9, 1953). These appeals followed, the taxpayers contending that the expenses, which were incurred by them in the course of patent litigation, were deductible from income as ordinary and necessary expenses within Section 23(a) (1) or (a)(2) of the Internal Revenue Code.

26 U.S.C. § 23 (1946 ed.).

The relevant facts, which are not in dispute, are as follows:

The taxable year involved is 1946. In that year, and since 1939, the taxpayers, George Gordon Urquhart, Radcliffe M. Urquhart and W.K.B. Urquhart, were participants in a joint venture engaged in the business of inventing, experimenting, developing, and exploiting patents and new processes, licensing and acting as licensor of patents and processes. In 1938 and 1940, George and Radcliffe Urquhart obtained two patents, Nos. 2,106,043 and 2,198,585, respectively, involving fire-fighting equipment. From 1942 through 1946, the sole business of the joint venture was the licensing of these two patents, and in those years the joint venture realized substantial royalties. In 1938, the title holders to patent No. 2,106,043 notified Pyrene Manufacturing Company (Pyrene) that it was infringing on their patent and threatened litigation. On April 28, 1943, they brought suit against American LaFrance Foamite Corporation, a customer of Pyrene, for infringement of both patents, seeking an injunction and recovery of profits and damages. This action was dismissed in April, 1943. On May 5, 1943, Pyrene commenced an action against the patent owners in the United States District Court for the Eastern District of Pennsylvania, seeking a declaratory judgment that both patents were invalid and that its own apparatus and methods did not infringe. A counterclaim was filed asking for an injunction against infringement, and an accounting for profits and damages. No question was raised by Pyrene in this action as to title to, or ownership of, the patents. The case came to trial in June, 1946 and later that year the District Court entered judgment in favor of Pyrene holding that the patents in question were invalid and void. The taxpayers expended $55,748.64 in 1946 for legal fees and other expenses in connection with this litigation, and it is this sum which is the subject of the instant controversy. This Court affirmed, holding the patent claims involved invalid for want of invention.

See Urquhart v. American-La France Foamite Corp., 1944, 79 U.S.App.D.C. 219, 144 F.2d 542, certiorari denied, 1944, 323 U.S. 783, 65 S.Ct. 273, 89 L.Ed. 625.

Pyrene Mfg. Co. v. Urquhart, D.C.E.D. Pa. 1946, 69 F. Supp. 555.

3 Cir., 1949, 175 F.2d 408, certiorari denied, 1949, 338 U.S. 826, 70 S.Ct. 73, 94 L.Ed. 502. The issues are clearly spelled out in the reported opinion and need not be reiterated here. An additional ground of invalidity was that certain claims were functional.

On July 22, 1949, National Foam System, Inc., the principal non-exclusive licensee of the two patents, commenced action against the two patentees seeking to be relieved of its license; a counterclaim was filed for royalties. On November 29, 1949, the patent owners brought an action in the Court of Claims against the United States asserting validity of their patents and claiming compensation for unauthorized use. In this action judgment was entered for the United States.

National Foam System, Inc., v. Urquhart, D.C.E.D.Pa. 1952, 103 F. Supp. 433, affirmed, 3 Cir., 1953, 202 F.2d 659.

Urquhart v. United States, 1953, 109 F. Supp. 409, 124 Ct.Cl. 441, which discloses that recovery was denied on the ground of misuse of the patents.

A partnership income tax return for 1946 was filed by the taxpayers, in which return deduction in the amount of $55,748.64 was taken for legal fees and litigation expenses. Each of the taxpayers, in individual returns for 1946, showed income from the joint venture in amounts determined after deduction of the expenses on the part of the joint venture. The Commissioner disallowed the deductions the taxpayers claimed on account of the litigation expenses treating them as capital expenditures. The Tax Court sustained the Commissioner's action, holding that "the taxpayers were engaged in defending a property interest, the exclusive right to make, use and vend these inventions granted by the patents and were only incidentally engaged in seeking to collect income."

We are of the opinion that the litigation expenses here involved were ordinary and necessary expenses incurred by the taxpayers in carrying on their trade or business, and that they were incurred as normal overhead or operating costs of their business activities. As such, they are deductible under Section 23(a)(1).

We have no doubt that these expenses were ordinary and necessary. Commissioner of Internal Revenue v. Heininger, 1943, 320 U.S. 467, 64 S.Ct. 249, 88 L.Ed. 171; Deputy v. DuPont, 1940, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416; Welch v. Helvering, 1933, 290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212; Kornhauser v. United States, 1928, 276 U.S. 145, 48 S. Ct. 219, 72 L.Ed. 505. There is no dispute that taxpayers were engaged in the business of exploiting and licensing patents. And we have no doubt that the expenses were directly connected with and proximately resulting from the conduct of taxpayers' business. Indeed, the expenditures and the manner in which they came into being are peculiarly normal to the business in which the taxpayers were engaged. It is not of decisive significance that the taxpayers were unsuccessful, at least since Commissioner of Internal Revenue v. Heininger, supra. Nor is it a requirement that the expenses have been incurred in the production of income, or actually productive of income. Bingham's Trust v. Commissioner, 1945, 325 U.S. 365, 65 S.Ct. 1232, 89 L.Ed. 1670.

Nevertheless, the Commissioner characterizes the expenses as capital, i.e., incurred in the defense or perfection of the equivalent of title. He cites Regulations 111, § 29.24-2, and the apparently settled law that expenditures for the defense or perfection of title are part of the cost of acquisition of capital assets. In this instance he brings that law into play by virtue of our determination in the Pyrene case of the issue of validity. But as we have said before "Taxation is an intensely practical matter, and, it deals with realities not semblances; with substance and not form * * *." It must ever be kept in mind "that the substance of the transactions will prevail over form". And, particularly in the area of taxation with which we are concerned, we "cannot ignore the ways of conduct and forms of speech prevailing in the business world." Commissioner of Internal Revenue v. Heininger, supra, 320 U.S. at page 472, 64 S.Ct. at page 253; Welch v. Helvering, supra. The litigation which gave rise to the expenditures in issue was commonplace patent infringement litigation. It is conceded that no question of title was involved. The form of the action and the circumstance that it was initiated by the alleged infringer do not, at least in this instance, alter the character of the controversy. The Urquharts brought about the litigation by asserting infringement; they forced the step by threatening Pyrene's customers and instituting action against one of them; such affirmative conduct upon the part of the Urquharts was the foundation of the declaratory judgment action. Moreover, in patent infringement actions, the defense of invalidity of patent claims is normally raised, and it is normally disposed of first. Sinclair Carroll Co., Inc., v. Interchemical Corp., 1945, 325 U.S. 327, 330, 65 S.Ct. 1143, 89 L.Ed. 1644; Rock-Ola Mfg. Corp. v. Cusano, 3 Cir., 1953, 206 F.2d 551, 553-554; compare Pyrene Mfg. Co. v. Urquhart, supra, note 4, 175 F.2d at page 411. In the light of the Urquharts' answer and counterclaim the situation was for general purposes the same as though they had commenced an infringement action against Pyrene. The declaratory judgment remedy merely enabled a turnabout of parties. Mere form of action is immaterial. Cf. Rassenfoss v. Commissioner, 7 Cir., 1946, 158 F.2d 764. Of course, it is well-settled that the Urquharts remained free to assert infringement against others in the courts, and this freedom extends to the issue of the validity of their patent claims.

Thompson v. Commissioner of Internal Revenue, 3 Cir., 1953, 205 F.2d 73, 78. See also Paxson v. Commissioner of Internal Revenue, 3 Cir., 1944, 144 F.2d 772, 776.

Berwind v. Commissioner of Internal Revenue, 3 Cir., 1943, 137 F.2d 451, 453.

Infringement litigation is a far cry from removing a cloud on title, or defending ownership of property. Here, it arose out of and related directly to the exploitation of the invention embodied in the patent. And, in our view, the purposes and intent are the same whether the Urquharts commenced the action, or maneuvered Pyrene into taking the initial litigative step. In Mathey v. Commissioner, 1 Cir., 1949, 177 F.2d 259, 262, which deals with the successful patentee, it was said, at pages 262-263:

"`"In patent nomenclature what the infringer makes is `profits,' what the owner of the patent loses by such infringement is `damages.'"' Duplate Corp. v. Triplex Safety Glass Co., 298 U.S. 448, 451, 56 S.Ct. 792, 793, 80 L.Ed. 1274, quoting Diamond Stone-Sawing Machine Co. of New York v. Brown, 2 Cir., 166 F. 306. And usually, although not always, what a patent owner loses from infringement is the acquisition of `a just and deserved gain' from the exploitation of the invention embodied in his patent. 3 Walker on Patents (Deller's Ed.) § 821. Therefore an award of damages in patent litigation is ordinarily an award of compensation for gains or profits lost by the patent owner and hence is taxable to him as income in the year received."

Since the Urquharts were engaged in the business of exploiting and licensing patents, we are the more clear that the litigation expenses were incurred to prevent (and recover) damage to their business, that is, to protect, conserve and maintain their business profits. There is no conflict apparent to us, as urged by the Commissioner, with the principle that expenditures which yield benefits over a period of years are not current operating expenses under Section 23(a)(1). Commissioner of Internal Revenue v. Surface Combustion Corp., 6 Cir., 1950, 181 F.2d 444; cf. Commissioner of Internal Revenue v. Heininger, supra. If this principle were applicable here, it would also apply to successful infringement actions like Mathey v. Commissioner, despite the recovery of damages, if only on a proportionate basis. It may be noted, incidentally, that in the patent phase of that case one of the claims of the patent was held invalid: United Shoe Machinery Corporation v. Mathey, 1 Cir., 1941, 117 F.2d 331. Cases like Safety Tube Corp. v. Commissioner, 6 Cir., 1948, 168 F.2d 787, and Falls v. Commissioner, 1946, 7 T.C. 66, exemplify situations in which title to patents are involved, and the expenditures incident to such issue are deemed capital in nature.

We conclude that the expenditures in controversy are within Section 23(a)(1) and are deductible as ordinary and necessary business costs. Kornhauser v. United States, supra; Rassenfoss v. Commissioner, supra; Hochschild v. Commissioner, 2 Cir., 1947, 161 F.2d 817; Levitt Sons v. Nunan, 2 Cir., 1944, 142 F.2d 795; Appeal of F. Meyer Brother Co., 1926, 4 B.T.A. 481. The expenditures were made in the course of business to protect against infringement and to recover profits and damages and they are not appropriate to be added to the cost of securing the asset, i.e., the patent.

In A.R.R. 98, 2 C.B. 105 (1920), the Committee on Appeals and Review had under consideration the deductibility of expenses incurred by a patent owner in an infringement action. It held: "The Committee is of the opinion that the amounts expended by this corporation after it secured the patent are not a part of the cost of the property for the reason that such amounts do not add to or prolong the life of the property in question and cannot be considered as an improvement or betterment. The amount so expended having none of the elements of improvement or betterment cannot be returned to the corporation through depreciation charges * * *. Only such amounts as represent the actual cost of this patent can be deducted by way of depreciation annually by this corporation. The title and ownership of the patent was in the corporation and the amounts expended were not made in perfecting its title to the patent already owned and used by the company.
The conclusion of the Committee is that the amounts expended by the corporation in the instant litigation, after the patent had been secured by B and had been transferred to the corporation constitute necessary operating expenses and should not be capitalized." 2 C.B. 105, 107-108.

For the reasons stated, the judgment of the Tax Court will be reversed and the cause remanded with directions to proceed in accordance with this opinion.

URQUHART v. COMMISSIONER OF INTERNAL REVENUE