Eskimo Pie Corp. v. Comm'r of Internal Revenue

Citation4 T.C. 669
Decision Date31 January 1945
Docket NumberDocket No. 2379.
PartiesESKIMO PIE CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
CourtUnited States Tax Court

OPINION TEXT STARTS HERE

1. Petitioner corporation entered into a contract whereby it guaranteed 30 percent of a principal debt of its wholly owned subsidiary and agreed to pay interest thereon at the rate of 3 percent per annum until the principal was paid. Held, that the annual payments are not deductible as interest within the meaning of section 23(b) of the Internal Revenue Code, as they were not interest payments on the indebtedness of the taxpayer, but of another.

2. The interest payments, which were made primarily for the purpose of protecting petitioner's capital investment in the subsidiary, are capital expenditures and are not deductible as ordinary and necessary business expenses.

3. The so-called royalty payments which petitioner contracted to pay were not ordinary and necessary expenses of carrying on petitioner's trade.or business. Ewing Everett, Esq., for the petitioner.

Francis X. Gallagher, Esq., for the respondent.

The Commissioner has determined deficiencies in the petitioner's income tax of $4,710.53 for 1938 and $4,157.70 for 1939.

The two issues involved are: (1) Whether certain payments, called royalties, accrued by petitioner and deducted by it from gross income, may properly be deducted, and (2) whether petitioner is entitled to a deduction from gross income for certain interest charges accrued by it during the taxable years.

Other issues raised by the parties were not pressed at the hearing and no proof was presented by petitioner.

Many of the facts have been stipulated by the parties and are found as stipulated. Other material facts are found from the evidence.

FINDINGS OF FACT.

The petitioner, Eskimo Pie Corporation, is a Delaware Corporation, organized August 14, 1922. It keeps its books and makes its tax returns on an accrual basis. Federal income tax returns for the taxable years involved were filed with the collector of internal revenue for the fifth collection district of New Jersey.

Prior to 1922 C. K. Nelson owned and held the patents and trade name of ‘Eskimo Pie.‘ At the time petitioner was organized the patents and trade name were turned over to it and have continuously been the property of petitioner. C. K. Nelson, C. F. Wade, C. O. Lund, and W. J. Hamlin owned the majority of petitioner's shares. Petitioner is not a distributor of Eskimo Pies. It licenses ice cream manufacturers in various localities to manufacture Eskimo Pie products under its trade name, in accordance with standards and formulae established by it. The patent expired prior to the taxable period involved herein.

The license agreements between petitioner and its manufacturer licensees provided that Eskimo Pie products would be sold only in foil wrappers to be purchased only from foil suppliers designated by petitioner. Among the foil suppliers designated was the United States Foil Co., hereinafter referred to as Foil, a Delaware corporation, organized in 1919. Under a contract in effect between petitioner and Foil, the latter would ship the wrappers to petitioner's licensees and collect from them. Foil would remit to petitioner $1 per 1,000 wrappers sold by it. This method of operation between petitioner and Foil continued until June 28, 1928.

In 1924 Foil, being desirous of obtaining more of petitioner's wrapper business, attempted to purchase for a cash consideration the respective shares owned by the following individuals: Nelson 14,768, Wade 14,300, Lund 5,250, and Hamlin 5,000. These persons will hereinafter be called the individuals. The individuals refused to sell for a cash consideration and demanded that they be paid a so-called royalty, hereinafter for convenience called ‘royalty payments,‘ on all foil and/or other wrappers which were used on Eskimo Pies. Individual contracts between Nelson, Wade, and Lund and Foil were executed on July 31, 1924, and an individual contract between Foil and Hamlin was entered into on May 20, 1925. Under these contracts Foil acquired the shares owned by the individuals and agreed to pay them royalties, computed at rates ranging from 10 cents up to 15 cents per 1,000 wrappers with respect to all foil and/or other wrappers used on Eskimo Pies and/or other edible coated ice cream bars. In 1924 Foil also purchased outright 3,240 shares of petitioner's stock from other owners. During the years 1925 to 1928, inclusive, Foil paid a total of $259,283.50 in royalty payments.

On June 28, 1928, petitioner granted Foil an exclusive license to manufacture, sell, and distribute metallic foil wrappers to petitioner's licensees engaged in the manufacture of Eskimo Pie products. Foil agreed to pay petitioner $1 per 1,000 wrappers sold and to allow petitioner 20 cents per 1,000 wrappers as an advertising allowance. This exclusive license had a 25-year duration under the terms of the contract.

In July 1928 the Reynolds Metals Co., a Delaware corporation, hereinafter called Metals, was organized. Metals took over the operating assets and liabilities of Foil, including its agreement with petitioner and the contracts with the individuals. Shortly thereafter, because of objections raised by the individuals, Metals reassigned the contracts between Foil and the individuals to Foil. In this agreement Metals obligated itself to pay Foil amounts sufficient to pay Foil's royalty payment obligations under revised contracts with the individuals. Foil retained the stock of petitioner it had acquired from the individuals and from other owners.

Metals, as assignee of Foil, operated under the exclusive agreement until November 1, 1928, when a new exclusive license agreement for a 10-year period was entered into between Metals and petitioner. All previous agreements were terminated and superseded by the contract. Payments to petitioners were increased to $1.45 per thousand. From the time of its organization until October 12, 1931, Metals manufactured the wrappers and sold them to petitioner's licensees. It paid petitioner as per its contracts and paid to Foil the royalty payments. Foil, in turn, paid the individuals. This contract was superseded by a new contract dated April 2, 1930, ending September 1, 1939, which provided the same as above, and made changes not material herein.

On October 12, 1931, a new contract between Metals and petitioner was executed and was to be in force and effect for five years from that date. It provided that Metals would sell all Eskimo Pie wrappers to petitioner for a period of five years at scheduled prices. Under this contract petitioner collected for the wrappers from its licensees and paid Metals for the wrappers, including the amount of royalty payments. Metals paid Foil, which in turn paid the individuals. Upon execution of this contract, the contract of April 2, 1930, ceased and terminated.

A supplemental agreement between Metals and petitioner, executed on January 2, 1933, provided that the Eskimo Pie Corporation of New York, hereinafter more fully described, should have the right to use paper bags or wrappers on Eskimo Pies sold by it. While this contract was in effect petitioner paid Metals for all wrappers used and Metals paid the royalties to Foil to be paid by it to the individuals. In 1935 a further supplemental agreement was entered into by Metals and petitioner canceling the above supplemental contract. It provided that petitioner and its licensees and subsidiaries should have the right to use paper wrappers and paper bags on Eskimo Pie products in consideration of petitioner paying to Metals the sum of 33 1/3 cents for each 1,000 wrappers used by petitioner's licensees. All other terms and conditions of the original contract dated October 12, 1931, were to remain in effect. About this time the petitioner company started manufacturing all wrappers used by its licensees. Paper wrappers were adopted because they were considerably cheaper and the nature of the business had changed. The 33 1/3 cents per 1,000 represented the amount of the royalty payments. This sum was paid by petitioner to Metals. The latter company paid Foil, which paid the individuals. This supplemental agreement was executed on December 3, 1935, and was in effect from February 1, 1934, until January 31, 1936.

During the period from January 31, 1936, the expiration date of the supplemental agreement last referred to, until June 1, 1937, there was no written contract between petitioner and Metals requiring petitioner to make royalty payments to Metals. Petitioner continued to send monthly reports to Metals and accrued on its books the royalty payments as an account payable to Metals. By contract dated June 1, 1937, specifically referred to hereinafter, petitioner again became obligated to collect and pay over the royalties during the taxable years here in question.

By contract dated November 22, 1937, between Foil and C. F. Wade, it was agreed that in lieu of the royalty payments theretofore provided for Foil would pay Wade the sum of $4,402.12 upon execution of the contract and $30,000 in installments of $500 per month for five years from December 1, 1937, to December 1, 1942. By contract dated March 2, 1938, between Foil and C. O. Lund, it was agreed that Foil would pay Lund $4,258.33 on execution of the contract and $30,000 payable at the rate of $6,000 per year for five years from March 2, 1938, to March 2, 1942.

By 1937 the Eskimo Pie Corporation of New York, hereinafter called the New York company, petitioner's wholly owned subsidiary, which had previously operated as petitioner's licensee in the New York area, was inactive and insolvent. The New York company had a number of creditors and was seriously in default on its obligations.

Petitioner had been endeavoring to obtain a licensee for the area but had not been successful. From a business standpoint the New York area represented the largest potential market...

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