The Income and Other Federal Taxes as Affected by Patents, Trade-marks, Copyrights and Goodwill

DEPRECIATION OF PATENTS, COPYRIGHTS, TRADEMARKS AND THE LIKE.

The subject of depreciation of patents, copyrights, etc. is becoming of greater importance each year, not only because of the large increase in number and value of the patents and copyrights earning financial returns for their owners, but also because of the education in the general principles of accounting among inventors and owners of patents. The necessity of filing an Income Tax statement was in many instances the circumstance that brought about the investigation. into accounting methods, and to this extent at least the Income Tax Law has been beneficial to many industries. Authors and inventors have been referred to, even proverbially, as poor business men, and it has not been unusual for practical, experienced manufacturers to express ignorance on the matter of properly depreciating intangible property of this nature. The owner of one large factory confided to the author that despite the fact that he had charged off depreciation each year for decades on all real property, machine tools, office equipment, and practically everything tangible, it had never occurred to him to charge depreciation of his patents. Even patent lawyers of long practice have not taken full advantage of the benefits that may be secured to their clients by adoption of proper depreciation methods, as witness the very few accounting cases after patent infringement wherein an allowance has even been sought for depreciation in value of the patents owned by a defendant company.

That patents, copyrights, licenses, and the like are proper subject matter for depreciation allowance is now a well-recognized principle of modern accounting. The Internal Revenue Bureau admits this and has laid down specific rules on this point.

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"Intangibles, the use of which in the trade or business is definitely limited in duration, may be the subject of a depreciation allowance. Examples are patents and copyrights, licenses and franchises. If a tangible asset acquired through Capital outlay is known from experience to be of value in the business for only a limited period, the length of which can be estimated from experience with reasonable certainty, such intangible asset may be the subject of a depreciation allowance." (Art. 163, Reg. 45, as amended by Treasurer's Decision 2929. 23-19-545.)

"An allowance for depreciation of patents will be made on the following basis: (Art. 137, Reg. 33, Rev.)

"Depreciation of intangible property as explained in Art. 163 of Reg. 45 applies to all intangible property, including patents and copyrights, whether acquired for cash, other property, or corporate stock. The term 'Capital outlay' includes corporate stock." (O. D. 344. 30-19-640.)

Even the method to be followed in computing depreciation for tax purposes has been specified by the Internal Revenue Bureau:

"The capital sum to be replaced should be charged off over the useful life of the property either in equal annual installments or in accordance with any other recognized trade practice, such as an apportionment of the capital sum over units of production. Whatever plan or method of apportionment is adopted must be reasonable and should be described in the return." (Art. 165, Reg. 45, Rev.)

"In computing a depreciation allowance in the case of a patent or copyright, the capital sum to be replaced is the cost (not already deducted as current expense) of the patent or copyright or its fair market value as of March 1, 1913, if acquired prior thereto. The allowance should be computed by an apportionment of the cost of the patent or copyright or of its fair market value as of March 1, 1913, over the life of the patent or copyright since its grant, or since its acquisition by the taxpayer, or since March 1, 1913, as the case may be. If the patent or copyright was acquired from the Government, its cost consists of the various Government fees, costs of drawings, experimental models, attorney's fees, etc., actually paid. If a corporation purchased a patent and paid for it in stock or securities, its cost is the fair market value of the stock or securities at the time of the purchase." (Art. 167, Reg. 45, Rev.) "An allowable deduction for any given year for return of Capital Invested in patents at time of issue will be an amount equal to 1/17th of the actual cost, in cash or its equivalent, of such patents. * * If the patent was purchased after a part of its life had expired, the cost for the purpose of a deduction for return of Capital will be ratably spread over the remaining years of its life." (Art. 174, Reg. 33, Rev.)

"Replacement value of property cannot be substituted for the cost of property, as the cost of replacement at a time some years in the future is a speculative figure which cannot be used as a basis for determining an annual depreciation charge. The depreciation charge will replace the amount of the original Capital outlay, which may be more or less than adequate to replace the item to which it applies. If less than adequate, new capital must be provided from surplus or otherwise to effect the replacement." (O. D. 283. 21-19-524.)

Prior to the approval of T. D. 2754 (Aug. 23, 1918) depreciation allowances were required to be based only on the cost of the property. This Treasury Decision authorized depreciation deductions based on the value of property as of March 1, 1913, if acquired prior thereto. The basis in the case of property acquired on or after that date remains unchanged.

In an opinion rendered by the Solicitor of Internal Revenue, it was held that T. D. 2754 is applicable to returns for 1913 and all subsequent years. This Treasury Decision was based on a prior opinion of the Solicitor of Internal Revenue, in which it was held that depreciation charges allowable for any year represent the portion of the gross income of the year necessary to make good a capital shrinkage; that the charges should therefore be such as to amount in the

aggregate during the life of the depreciating property to the value of that property as a capital asset; and that under the U. S. Supreme Court decisions in Doyle vs. Mitchell Bros. Co., 247 U. S. 179, and Lynch vs. Turrish, 247 U. S. 221, this capital value should be determined as of March 1, 1913.

To demonstrate the working of this method, the procedure to be followed will be set out here step by step.

1. The determination of the cost of the patent or copyright to the then owner must be made in accordance with the rules laid down by the Bureau, and this cost should be entered on the books as a Capital asset.

"If a patent or copyright is acquired from the Government, the cost thereof is the amount actually expended by him in developing and securing the patent." (Art. 167, Reg. 45, Rev.)

"If the patent or copyright is purchased from another, the cost thereof is the amount actually paid over; if the purchase price be in stocks, bonds or like securities, the cost price is the fair market value of such stock or other securities at the time of the purchase." (Art. 167, Reg. 45, Rev.)

"Amounts expended for securing a copyright and plates, which remain the property of the person making the payments, are investments of capital." (Art. 293, Reg. 45, Rev.)

2. The remaining years of life of the patent or copyright should be computed and a corresponding percentage of the cost as ascertained above used for the amount of depreciation each year.

"An allowable deduction for any given year for return of Capital invested in patents at time of issue will be an amount equal to 1/17th of the actual cost of such patents. * If the patent was purchased

after a part of its life had expired, the cost for purpose of a deduction for return of 'Capital will be ratably spread over the remaining years." (Art. 174, Reg. 33, Rev.)

"With respect to the depreciation of patents, 1/17th of the cost is allowed as a proper deduction each year until the cost of the patent has been returned to the corporation." (Art. 138, Reg. 33, Rev.)

3. At the end of each year the annual depreciation (as determined above) should be charged off on the books. This is usually done either by deducting this amount from the book value of the patent or by crediting this amount to a Depreciation Reserve Account.

"A depreciation allowance, in order to constitute an allowable deduction in Gross Income, must be charged off. The particular manner in which it shall be charged off is not material, except that the amount measuring a reasonable allowance for depreciation must be either deducted directly from the book value of the assets or preferably credited to a Depreciation Reserve Account, which must be reflected in the annual balance sheet." (Art. 169, Reg. 45, Rev.)

"A corporation is not entitled to a deduction from the amount of its Gross Income of any amount of depreciation, depletion, or other loss

sustained within the taxable year unless the amount of such depreciation, depletion, or other loss is charged off on the books of the corporation before such deduction is allowed. The purpose of this requirement that depreciation, depletion, and other losses be charged off on the books of the corporation before allowance is to insure that the returns of such corporation are in accord with its books of account, and that thereby error and fraud with respect to the facts are prevented." (Letter signed

by Commissioner Roper, June 25, 1918.)

The procedure when several patents are owned is substantially the

same.

Where several patents are owned by the same individual or corporation and are carried on the books under the same Capital Asset Account, it is preferable, when possible, to add to this amount the cost of each patent as acquired, or, when this is not possible (see page 75) the amount representing the cost of the patents acquired during the year should be entered in the Capital Asset Account.

Then, preferably, the percentage of depreciation of each patent is separately computed, and the aggregate amount of such individual depreciations either deducted from the book value of the account or credited to the Depreciation Reserve. When this is not feasible, the total number of years the several patents have yet to run is ascertained and then divided by the number of patents to determine the average life of the entire group of patents. The corresponding percentage of the cost of the entire group is then charged off on the books.

Where it happens that a patent owner has not charged off depreciation in preceding years, he is not permitted because of this to charge off the entire cost during the remaining years.

Art. 167, Reg. 45, specifies:

"The fact that depreciation has not been taken in prior years does not entitle the taxpayer to deduct in any taxable year a greater amount for depreciation than would otherwise be allowable."

But he is permitted to go back and re-open his books for the prior years and then charge off the depreciation in the proper years.

"The Statute is not, however, to be construed as requiring that depreciation, depletion and other losses be charged off within the taxable year. It is sufficient that they are charged off before they are allowed as deductions. Consequently, at the time of an examination of a corporation it should be given an opportunity to reopen its books and charge off depreciation, depletion and other losses which it actually sustained during the taxable year. * * * Whenever, therefore, a corporation has clearly suffered allowable depreciation, depletion or other loss which has not been charged off on its books and on reopening its books at the time of an examination charges off such depreciation by proper entry, it is entitled to the benefit of the deduction of such depreciation, depletion or other loss subject to the general provisions of law." (Letter to Internal Revenue Agents, dated June 25, 1918.)

There are occasions, however, when the assets of the company have in the intervening years been disposed of, so that it would be inequitable to permit the reopening of the books for entry of the depreciation allowances.

“The depreciation, depletion and other losses must be charged off in the manner prescribed by the Regulations. If the books of the corporation are reopened for the purpose of charging off depreciation, etc., corresponding corrections must be made in the other book entries; and if for any reason the facts do not warrant such other charges, depreciation, etc., cannot be charged off, and therefore cannot be allowed as deductions. Thus, for example, if by reason of a distribution of earnings, there is nothing from which to credit a reserve for depreciation, no allowance for depreciation can be credited to a Depreciation Reserve Account." (Letter to Internal Revenue Agents, June 25, 1918.)

It has been held that an owner of a part interest in a patent or group of patents has the right to deduct each year a percentage of his part of the cost value by way of depreciation.

"A invented certain apparatus and secured U. S. patents thereon. The patents were assigned to a foreign corporation under an agreement by which he retained 40% interest in profits therefrom. Legal title to the patents passed to the company, subject to the agreement mentioned. A's interest was recognized by the company and by the U. S. licensees under the patents. The Committee is of opinion that the agreement should be recognized as giving A a depreciable interest in the patents.

Of the total depreciations allowable for any year, 60% is deductible in the return of the company and 40% in A's return." (A. R. M. 35. 10-20-779.) Foreign patents owned by a person or company doing business in the United States may also be depreciated. The following table showing the usual duration of patents issued by various countries has been recently published by the Treasury Department for guidance in computing annual depreciation :