Joe L. Schmitt, Jr., and Helen N. Schmitt, Petitioners, v. Commissioner of Internal Revenue, Respondent, 271 F.2d 301 (9th Cir. 1959)

The crucial question in this case is whether for income tax purposes an agreement executed by the taxpayer¹  constituted a sale of patent rights, and income derived therefrom was therefore long term capital gain; or whether the contract constituted a license, and hence income derived therefrom ordinary income.

The Tax Court held²  there was not a sale of all substantial rights in and to the patent, and hence the income was taxable as ordinary income. The taxpayer appeals. This Court has jurisdiction.³ 

Joe L. Schmitt, Jr. engaged in accounting work in Arizona for many years. He developed a procedure (described as Exact-O-Matic System) which was an automatic, mechanical process or accounting method, using tabulating cards and electrical circuits (a special wiring unit invented by taxpayer) to evaluate single entry information and convert that information into double entry records and accounting statements.

During the years in question (1949, 1950 and 1951),⁴  taxpayer entered into eleven substantially similar agreements whereby he transferred to assignees certain rights in certain specified territorial areas.

In return for said assignments, taxpayer received payment in two forms — first, "lump sum payments" of $7,962.02, $36,992 and $10,997, respectively, in the three tax years in question, and second, in the two latter years, $7,498 and $1,799, respectively, for the licensing by the territorial assignees of sublicenses or "District Franchises" located within the original assigned territory. These latter, or "paragraph 6(b) royalties," were reported by the taxpayer as ordinary income and are not involved in this appeal.

Both parties to this litigation recognize, as did the Tax Court, the intent of Congress in enacting this legislation with respect to the assignment of patent rights to establish a "realistic" test as to whether or not a "sale" had taken place; that "the entire transaction, regardless of formalities, should be examined in its factual context to determine whether or not substantially all rights of the owner in the patent property have been released to the transferee, rather than recognizing less relevant verbal touchstones."⁵  And see the quotation of the Tax Court judge of his own language in Rose Marie Reid, 1956, 26 T.C. 622, 632 (supported by cases there cited).

Using such test, the Tax Court concluded "that petitioner retained, in the aggregate, such continuing right and interest in the system as to preclude (recognizing) these transactions as sales." The court's opinion specified fifteen rights reserved, or limitations upon that which was assigned. These are set out in abbreviated form in the margin.⁶ 

The government urges that these "restrictions" are enough to support the Tax Court's decision, relying on William M. Bailey Co., 1950, 15 T.C. 468 (1950), affirmed per curiam, 3 Cir., 1951, 188 F.2d 360, and more particularly, Watkins v. United States, 3 Cir., 1958, 252 F.2d 722.

Additionally appellee points out that the provisions of paragraph 12 of the agreement here go further than the facts of Bailey v. Com'r, supra, in that there the agreement provided that the assignee company would prosecute or defend any infringement suits at its own expense. In the contract before us, paragraph 12 requires the assignor to so defend.

The general law is well established. An assignment of the exclusive right to manufacture, use, and sell a patented article within the United States or a specified area thereof amounts to a sale of the patent rights, and the income therefore is taxable as long-term capital gain, provided the invention is a capital asset and has been held for the required period. Anything less is a license. Whether payment is made in a lump sum or over a period of time is immaterial. Waterman v. Mackenzie, 1890, 138 U.S. 252, 11 S. Ct. 334, 34 L. Ed. 923; Arthur C. Ruge, 1956, 26 T.C. 138. But this applies to an exclusive right (or an undivided part or share in that exclusive right). A transfer which is not exclusive, or is limited (other than territorially), becomes a license and not an assignment. Waterman v. Mackenzie, supra; Watson v. United States, 10 Cir., 1955, 222 F.2d 689; Vincent A. Marco, 1955, 25 T.C. 544, 548; Edward C. Myers, 1946, 6 T.C. 258. "Where he [the patentee] transfers less than all three rights to make, use and vend for the term of the patent, or transfers them nonexclusively, the transfer is a mere license and does not convey any title in the patent itself." Kimble Glass Co., 1947, 9 T.C. 183, 190, quoted in William M. Bailey Co., 15 T.C. 468 at page 484. But there are exceptions to the Waterman rule. United States v. Carruthers, 9 Cir., 1955, 219 F.2d 21; Allen v. Werner, 5 Cir., 1951, 190 F.2d 840; Kavanagh v. Evans, 6 Cir., 1951, 188 F.2d 234.

Here the eleven substantially similar agreements used the terms "Assignor" and "Assignee." They did not purport to grant the exclusive right to "make, use and vend." Assignor granted unto assignee "the exclusive right, privilege and franchise to use and sell (not to manufacture) the said Exact-O-Matic System," during the entire term of said patents, "subject however, to the conditions and covenants hereinafter set forth." (Emphasis added.)

Admittedly, the nomenclature used to describe the contract and the parties thereto, has little, if any, value or significance in resolving the question whether there was an assignment or a license. How or what the parties are designated does "not fix, limit, or qualify the scope and effect of the grant."⁷ 

Nor do we hold the transfer of the exclusive right to use and sell, without the right to manufacture, establishes as a matter of law there was no sale. Whether the right to make is "substantial" often becomes a factual question, to be determined according to the facts and circumstances of each case and the peculiarities inherent in each patent.⁸  To this extent we distinguish the leading case of Waterman v. Mackenzie, supra. And see Parke, Davis & Co., 1934, 31 B.T.A. 427.

The case of Dairy Queen of Oklahoma Inc. v. Commissioner of Int. Rev., 10 Cir., 1957, 250 F.2d 503, is heavily relied on, as it should be, by appellant. Some of the facts are strikingly similar, even to the reporting by the taxpayer of gallonage royalty as ordinary income and lump sum payments due under the same agreement as long-term capital gains.⁹  On the facts of that case, the majority of the court in the Dairy Queen case ruled there was a sale.¹⁰ 

Judge Lewis, in dissenting, came to the opposite conclusion on those same facts.

While we might be inclined to favor the reasoning of the dissent in the Dairy Queen case, we need not pass on the facts of that case here, nor overrule it. The facts in the present case are similar, but not identical.

Nor do we quarrel with the legislative history defining "all substantial rights to a patent."¹¹  Just as the Senate Finance Committee felt it obvious that a transfer terminable at will by the transferor would not qualify as a sale, so do we. Where to draw the line between the two extremes is our problem.

Here the territorial assignee had an affirmative duty (a) to establish a district licensee within thirty days, and (b) to establish three district licensees thereafter. Not only were the forms of these licenses prescribed, but the taxpayer had an unlimited veto on the approval of any or all such district licenses. While such affirmative provisions may be compared to the 5,000 gallons of product required to be sold by Dairy Queen each season, or the minimum number of carts required to be sold in the six months period mentioned in Watson v. United States, supra, or even dismissed as unsubstantial, we think, realistically considered, they more closely resemble a licensor's control of a licensee than an assignor's sale of "all substantial" property rights.

But there are other and further reasons for the Tax Court's decision. Not only was the typical example of the territorial assignment of patent contracts in evidence, but likewise a December 23, 1949 contract between taxpayer and Exact-O-Matic Corporation, an Arizona corporation (dated only 1950, attached as Ex. 4-d to the Stipulation of Facts). This agreement refers twice to territorial franchises "already established or to be established." (¶¶ 2, 5.) If such prior territorial assignment of patents by taxpayers was intended to constitute a sale of all substantial rights, the language used in paragraph 1 of said December 1950 agreement is entirely inconsistent and incongruous. In that December 1950 agreement taxpayer represented that he was "the sole owner of the entire right, title and interest in and to those certain U.S. Patents * * * referred to * * * [as] * * * Exact-O-Matic System." (¶1, Ex. 4-d, Stipulation of Facts.) (Emphasis added.)

We thus are faced with the generally accepted rule that if there are present in the territorial license agreements, or in some closely related document which must be considered a part of the same transaction, factors which expressly negative an intent to make a transfer of the patent, the transaction cannot be held the equivalent of an assignment or sale. See Eterpen Financiera Sociedad de Responsabilidad Limitada v. United States, 1952, 108 F. Supp. 100, 124 Ct. Cl. 20, certiorari denied 1953, 346 U.S. 813, 74 S. Ct. 22, 98 L. Ed. 340; Rhodes-Hochriem Mfg. Co. v. International Ticket Scale Corp., D.C.Del.1932, 57 F.2d 713; Federal Laboratories, Inc., 8 T.C. 1150 (1947).

A further factor rightly emphasized by the Tax Court was that that which was transferred, if it were to be placed in operation, was required to use a certain wiring unit made by Remington-Rand to taxpayer's order. Title to this indispensable adjunct to the Exact-O-Matic was retained by taxpayer.

Another factor (which is commented upon in the Eterpen case, supra) is paragraph 12 of the "Territorial Assignment of Patent" relating to patent litigation. "Assignor agrees to defend at his own expense any litigation arising within or without the territorial area, challenging his right to use any of the aforesaid patents, etc." (Emphasis added.) Here, as in Eterpen, the agreement involved failed to expressly confer upon the assignee the right to sue for infringement of the patents in its own name. Of course, no express reservation to the contrary was included. Hence the assignment to use would ordinarily give assignee the right to sue jointly with the assignor, and the right to sell would ordinarily give the assignee the right to sue in his own name for infringement. Waterman v. Mackenzie, supra. Here the sole reference to the assumption by assignor of the obligation to defend his patents is persuasive of a license. We say persuasive, for admittedly such language is not conclusive. Pike v. United States, D.C.Conn.1951, 101 F. Supp. 100.

We concede the question may be close, but a careful examination of the evidence convinces us the Tax Court clearly had before it sufficient evidence of the retention of rights in the patented and copyrighted system, and of limitations imposed on the transferees, sufficient to establish that less than "all substantial rights" had been transferred.

Taxpayer seeks throughout his brief to bring himself within the theory of Dairy Queen, supra, by urging that the restrictions and reservations came into being in order to protect the value of the system and to prevent the system from falling into the hands of unskilled non-accountants.

While the motives which prompt certain agreements may be wholly laudable from a business or an ethical standpoint, they do not excuse or palliate the provisions and definitions of the law which the Congress, in its wisdom, has seen fit to promulgate. Nor are we permitted to change the law because a taxpayer is a good citizen and had the best of intentions.

The judgment of the Tax Court is affirmed.