Before HASTINGS, Chief Judge, and SCHNACKENBERG and KNOCH, Circuit Judges.
Fromm Laboratories, Inc., the taxpayer, has petitioned us to review a decision of the Tax Court of the United States.*fn1 This decision sustained the Commissioner's determination of certain deficiencies in federal income tax for the taxable years ending May 31, 1951 through May 31, 1954.
The deficiencies arose from the Commissioner's disallowance of (1) deductions taken by petitioner in each of the years involved as amortization of research and development cost of certain patents and (2) the inclusion by petitioner of this cost for research and development in its equity invested capital as paid-in surplus for the purpose of computing its excess profits tax for the years 1951, 1952 and 1954. The Tax Court sustained the Commissioner's disallowance. Fromm Laboratories, Inc., P-H 1960 T.C.Mem.Dec. 60,202 (1960).
The question presented for review is whether the Tax Court erred in sustaining the Commissioner's disallowance of these two items.
There is no dispute as to the relevant facts found by the Tax Court and stated in its opinion. They may be generally summarized in the following narrative.
The four Fromm brothers were pioneers in raising fur-bearing animals for the purpose of selling their pelts. Before 1929, the fur producing activities were carried on in part through a joint venture operated entirely by the brothers and in part through a joint venture operated by them and Edwin J. Nieman.
Fromm Bros., Inc., whose capital stock was owned by the brothers in equal proportions, and Fromm Bros., Nieman & Co., whose stock was owned one-half by Fromm Bros., Inc. and the four brothers and one-half by Edwin J. Nieman and his wife, were formed in 1929 to carry on the fur producing business in place of the joint ventures. At all times since July, 1933, Fromm Bros., Inc. has held a controlling interest in Federal Silver Fox Farms, Inc. and Fromm Bros. Silvercross Fox Farm, Inc. These corporations were formed to engage in the business of raising fur-bearing animals. Edward Fromm has at all times been president of all four corporations.
Many of the principal activities of the four Fromm fur corporations were conducted cooperatively. These included farming out the young foxes to the furring ranges, trapping, killing and pelting the foxes, and marketing the pelts. The expenses involved were borne initially by Fromm Bros., Inc. but were allocated periodically among all four corporations on the basis of the number of foxes which each placed on the ranges. The amount so allocated to each particular corporation was deducted by each, in turn, on its income tax return as a current operating expense. The proceeds, likewise, were received by Fromm Bros., Inc. and later allocated to each particular corporation.
In the winter of 1921, the Fromm brothers began to experience deaths in their fox herds. They attributed these losses to disease but could find no medical preparation which would meet their problem. In 1924, Robert Gladding Green, M.D., a member of the faculty of the University of Minnesota, went to the Fromms and expressed a desire to do research on their disease problem. The Fromms agreed and Green began his work. In a short time, Green determined that one of the diseases affecting the foxes was fox encephalitis, and he developed a serum to combat this disease. Large amounts of this serum were used from 1930 to 1939 to inoculate most of the silver fox pups of the four Fromm corporations without any separate charge being made therefor. During this early period, Green also developed a fox distemper serum which was likewise used to inoculate the fox herds, without any separate charge.
Until 1929, when Fromm Bros., Inc., and Fromm Bros., Nieman & Co., were organized, the four Fromm brothers paid all the expenses and furnished all of the animals incident to Green's work. Thereafter, from 1929 through 1944, substantially all of Green's expenses at the University of Minnesota and also certain amounts paid to him and his associates as salary were paid initially either by Fromm Bros., Inc. or by Fromm Bros., Nieman & Co.; these expenses were then, at least from 1933 through 1944, the pertinent period, allocated among all four Fromm corporations on the basis of the number of breeder animals which each owned. The amounts so allocated were then taken by these corporations into their books of account as current operating expenses and were deducted by them as operating expenses on their corporate federal income tax returns.
In about 1933, Green anticipated that his work might result in patents having commercial value. He suggested the formation of a corporation in which he would have an interest and to which title to any possible patents would be assigned. Edward Fromm agreed, and petitioner, taxpayer-corporation, was organized on July 29, 1933. At the time of incorporation, Green was issued 245 shares of stock out of a total issue of 500, and Fromm Bros., Inc., Edward Fromm and Walter Fromm were issued the remaining 255 shares. In 1939, after Green had obtained one patent for a distemper vaccine process and had filed application for two other related patents, the stock was redistributed so that one-half was owned by Green and his attorney and one-half by the four Fromm corporations, Edward Fromm and Walter Fromm. As with the four Fromm corporations, Edward Fromm was president of petitioner at all material times.
The organization of petitioner did not alter the procedure of allocating expenses to each of the four Fromm corporations and the subsequent deduction of these expenses by each of them.
In 1935, Fromm Bros., Nieman & Co. purchased the Lakefield Ranch. From that time, petitioner conducted its activities there. In 1945, petitioner purchased the ranch, financing the ...