Walt Disney Productions v. U.S., 76-1114

• Citation: 549 F.2d 576
• Decision Date: 05 August 1976
• Docket Number: No. 76-1114,76-1114
• Parties: 76-2 USTC P 9606, 77-1 USTC P 9398 WALT DISNEY PRODUCTIONS, Appellee, v. UNITED STATES of America, Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)

Page 576

549 F.2d 576

76-2 USTC P 9606, 77-1 USTC P 9398

WALT DISNEY PRODUCTIONS, Appellee, v. UNITED STATES of America, Appellant.

No. 76-1114.

United States Court of Appeals, Ninth Circuit.

Aug. 5, 1976.

As Amended Jan. 18, 1977.

Gilbert W. Rubloff, Atty. (argued), Tax Div., U. S. Dept. of Justice, Washington, D. C., for appellant.

John Cooley Baity (argued), of Donovan, Leisure, Newton & Irving, New York City, for appellee.

Before CHAMBERS and GOODWIN, Circuit Judges, and SCHNACKE, ^* District Judge.

ALFRED T. GOODWIN, Circuit Judge:

Walt Disney Productions sued for a tax refund, claiming the investment tax credit under 26 U.S.C. §§ 38, 46-50 (1970), for the cost of fourteen film negatives produced in 1970. The district court granted the refund, and rejected two government counterclaims. We affirm in part, and remand for further hearing on one of the counterclaims.

Some understanding of motion picture technology is necessary before we discuss the statute which grants qualified taxpayers an investment tax credit. Although the end product (an exhibition print) will provide both sound and a moving picture when projected, the audio and video portions of a film are separately processed in the initial stages of production. From the filming and editing of the original film negatives, a cut-picture negative (which does not contain sound) is produced. Meanwhile, audio experts record, edit, and mix three different types of sound tapes (music, dialogue, and sound effects), synchronize those sounds with a working print of the film, and then combine the synchronized and edited tapes into a magnetic master sound tape. At this point, the video (cut-picture negative) and audio (master sound tape) portions of the film are still separate. The master sound tape and the cut-picture negative (hereafter called collectively the "master negative") are durable items, and the steps necessary to produce them need not be repeated to create exhibition prints. It is for the production costs of the master negative that Disney seeks the investment tax credit.

Since commercial movie projectors play sound from optically recorded sound tracks, rather than from magnetic tapes, an optical sound negative is produced from the magnetic master sound tape. The optical sound negative in combination with either the cut-picture negative or an intermediate printing item (e. g., duplicate negative, color reversal internegative, or matrix) which is produced from the cut-picture negative, is then used to make an "answer print" for viewing by Disney's executives. The term "completion negatives" will refer to the items derivable from the cut-picture negative and the magnetic master which are used directly to strike exhibition prints.

The "answer print," when approved by the executives, represents the version to be exhibited. Equivalents of that print (positive release exhibition prints) are then made using the cut-picture negative (or an intermediate printing item) together with an optical sound negative. Unlike the master negative (the cut-picture negative and magnetic master sound tape), the completion negatives (optical sound negatives and intermediate printing items) are short lived. They can be used to make an average of only 100 to 150 exhibition prints. Accordingly, Disney must periodically use the master negative to provide new completion negatives for the production of exhibition prints. To preserve the value of the exhibition rights, Disney secures a statutory copyright on the photoplay (the picture image and sound) of each exhibition print. See 17 U.S.C. §§ 1, 5(l ), 10 & 13 (1970). The complete process of production is outlined in the sketch opposite. ¹

In calculating the investment credit, Disney claims all the capitalized costs ² necessary to produce the master negative; it does not claim the costs incurred in producing the completion negatives. Disney does not claim as investment-credit property the original or edited dialogue, music, or sound-effects tapes, but Disney does claim the expense for those items in computing the production costs of the master negative.

In calculating the basis for depreciation of the film titles, Disney capitalized the costs of producing its answer prints, ³ including the costs of the optical sound negatives ⁴ but not including the costs of the intermediate printing articles. In depreciating each film title, Disney uses the income-forecast method ⁵ a scheme generally used for depreciating intangible personal property.

I.

On its tax return for fiscal year 1970, Disney claimed, as it had for all prior years since 1962, an investment tax credit equal to seven percent of its alleged qualified investment in the master negatives produced during that taxable year.

The Commissioner disallowed the investment tax credit on the ground that Disney's production costs were investments in intangible property: a copyright-protected motion picture. The government maintains that, while a master negative includes tangible items (such as film stock and tapes), these tangible "things" have no separate identities or depreciation bases for tax purposes apart from the photoplay and intangible rights included in the finished product.

The master negatives in issue here are the same type of property we earlier characterized as qualifying for the investment tax credit. Walt Disney Productions v. United States, 327 F.Supp. 189 (C.D.Cal.1971), aff'd as modified, 480 F.2d 66 (9th Cir. 1973), cert. denied, 415 U.S. 934, 94 S.Ct. 1451, 39 L.Ed.2d 493 (1974) (Disney I ); Walt Disney Productions v. United States, 1974-2 U.S. Tax Cas. P 9623 (C.D.Cal.1974), appeal dismissed per stipulation, No. 74-2988 (9th Cir. Jan. 17, 1975) (Disney II ).

Since Disney I & II concerned different master negatives and different taxable years than those in issue here, the present case lies outside the narrow scope of res judicata and collateral estoppel applicable to tax litigation. See Commissioner v. Sunnen, 333 U.S. 591, 68 S.Ct. 715, 92 L.Ed. 898 (1948). However, the earlier holdings have value as precedent and are binding upon this court until overruled by this court en banc or by the Supreme Court.

First, we agree with Disney I that master negatives are tangible property within the meaning of 26 U.S.C. § 48(a)(1) (1970) and that the investment tax credit can be claimed for the production costs of such property. Disney can claim the full 7% credit on the costs in issue here because the parties have stipulated that the elements of the master negative (the cut-picture negative and master sound tape) have a useful life of more than eight years. See 26 U.S.C. § 46(c)(2) (1970).

The master negatives for each film title are used by Disney as a capital asset to create exhibition prints for rental or sale. Most of the value of the exhibition prints rests on the right of exclusive exploitation protected by copyright, but that fact does not render the capital asset (the master negatives) an intangible. A machine which stamps out patented products for sale is tangible. The character of the acquisition costs of that machine is not affected by the character of the end product, even if the value of the entire system is dependent on the patent, i. e., an intangible.

Second, the government asserts that, for purposes of depreciation, Disney has treated its film property as an intangible by including in the depreciation basis costs beyond those required to produce the master negative and by using the income-forecast method of depreciation. Noting that this court held in Disney I that basis for the investment tax credit does not have an idiosyncratic meaning and that the court therefore authorized use of the full depreciation basis in calculation of the credit, ⁶ 480 F.2d at 69, the government argues that when for purposes of depreciation Disney treats its film property as an intangible, that property should also be treated as an intangible when Disney seeks the investment tax credit.

Although the basis Disney now claims for depreciation differs in amount from that claimed for the investment credit, this difference does not demonstrate that Disney is actually seeking the credit for an intangible (a motion picture). We believe that the appropriate property for purposes of the credit is the master negative for each film title. Inclusion of the optical sound...